Interpretations Fundamental Made from Financial Statement Data SOLUTIONS: E3-1. a. Amount of return ROI = Amount invested Julie: $50 $560 = 8.93% $53 Sam: $620 = 8.55%
Julie's investment is preferred because it has the higher ROI. b. Risk is a principal factor to be considered. E3-2. a. Interest earned on the savings account: $1,200 * 5.5% * 6/12 = $33. b. Interest earned on loan to Judy: ($1,240 amount repaid - $1,200 amount loaned) = $40. Rate of return for 6 months is $40 / $1,200 = 3.3% Rate of return on an annual basis is 6.6% c. The loan to Judy promises a higher return than the rate earned on the savings account (6.6% versus 5.5%), but this may not be enough to compensate your friend for the risks and inconveniences involved with an unsecured personal loan. Query: Does Judy have a good credit history? Will she repay the $1,240 as promised? Will her repayment be on time? Will your friend incur any collection expenses? Is your friend willing to tie up her money for six months and lose the convenience of her demand deposit account? E3-3. Solution approach: Calculate the amount of return from each alternative, then calculate the ROI of the additional return from the higher paying investment relative to the $200 that must be invested to get the higher return. ROI * amount invested = amount of return. Alternative # 1 10% * $500 = $50 return. Alternative # 2 11% * $700 = $77 return. The extra amount of return of $27 on an additional investment of $200 is an ROI of 13.5%. ($27 / $200 = 13.5%). Therefore, do not pay an interest rate of more than 13.5% to borrow the additional $200 needed for the higher yield investment. E3-4. a. $800 * 6% = $48 return. b. Return on $1,000 at 8% = $80 Cost of $200 at 15% = $30 Net return = $80 - $30 = $50 E3-4. (continued) c. Net return / Investment = ROI
Chapter 3 $50 / $800 = 6.25% Solution Approach: A prudent investor would be wise to take the following factors into consideration before choosing between alternative investment opportunities: 1. How long is the investing horizon of each investment? In this case, both investments were for one year. If this were not the case, the rate of return calculation would have to be "annualized" before a valid comparison could be made between the alternative investments. Rate of Return = Principal x Interest x Time. 2. How flexible is the investment? In this case, the savings account would be more flexible than the certificate of deposit because money can be withdrawn (or deposited) on a day to day basis in a savings account without penalty. 3. What is the relative risk of each investment? In this case, both investments would be considered "risk free" (i.e., certain) because bank savings accounts and certificates of deposit are both backed by the FDIC. If one of the investments were riskier than the other (i.e., an investment in a start-up corporation's common stock), then a prudent investor would demand a higher rate of return on the riskier investment as compensation for the additional risk inherent in the investment. 4. How does each alternative investment "fit" within the investor's overall portfolio? The text does not cover Modern Portfolio Theory or similar "Finance" topics, but it is worth noting that individual investments must be considered within the context of the investor's overall portfolio. An investment in Company X that may appear to be "too risky" when analyzed in isolation, but it may in fact be risk-reducing and returnenhancing when viewed as "part of" an investor's overall portfolio. 5. How does each alternative investment fit within the investor's investing objectives? Different people invest for different reasons. A young couple in their 20's or 30's may wish to save for their retirement or for the college education of their children. As such, they would be more inclined to invest in a "growth" portfolio than would be a couple in their 60's or 70's who would be more likely to invest in an "income" oriented portfolio. Subjective factors may also be taken into account, such as level of "social responsibility" taken on by each of the companies whose stock is being considered for investment.
E3-5. The following model can be used to help answer any questions related to ROI: ROI = MARGIN x TURNOVER
NET INCOME NET INCOME SALES AVERAGE TOTAL ASSETS = SALES x AVERAGE TOTAL ASSETS a. 18% ROI = 12% Margin * ($600,000 Sales / Average total assets)
Fundamental Interpretations Made from Financial Statement Data Average total assets = $400,000 b. ROI = ($78,000 Net income / $950,000 Average total assets) = 8.21% 1.3 Turnover = (Sales / $950,000 Average total assets) Sales = $1,235,000 Margin = ($78,000 Net income / $1,235,000 Sales) = 6.32% ROI = (6.32% Margin * 1.3 Turnover) = 8.21% c. 7.37% ROI = (Margin * 2.1 Turnover) Margin = 3.5% E3-6. a. Margin = ($27,900 Net income / $930,000 Sales) = 3% Turnover = ($930,000 Sales / $465,000 Average total assets) = 2.0 ROI = (3% Margin * 2.0 Turnover) = 6% b. Margin * Turnover = ROI ($75,000 Net income / $1,250,000 Sales) * Turnover = 15% ROI (6% Margin * Turnover) = 15% ROI Turnover = 2.5 2.5 Turnover = ($1,250,000 Sales / Average total assets) Average total assets = $500,000 c. (Net Income / $1,730,159 Average total assets) = 12.6% ROI Net Income = $218,000 1.4 Turnover = (Sales / $1,730,159 Average total assets) Sales = $2,422,222 Margin = ($218,000 Net income / $2,422,222 Sales) Margin = 9%
E3-7.
Remember that "net assets" is the same as "owners' equity." Beginning net assets.............................................................. Add: Net income................................................................... Less: Dividends..................................................................... Ending net assets.................................................................. ROE = Net income / Average owners' equity = $42,300 / (($346,800 + $377,100) / 2) = 11.7% $346,800 42,300 (12,000) $377,100
E3-8. a. Margin * 2.4 Turnover = 12% ROI Margin = 5% 5% Margin = (Net Income / Sales $12,000,000)
Chapter 3 Net Income = $600,000 (or $0.6 million) b. ROE = ($600,000 Net income / $3,000,000 Average owners' equity) = 20% E3-9. a. Current assets......................................... - Current liabilities .................................... = Working capital. .................................... Current ratio........................................... Do Not Prepay Accounts Payable $ 12,639 (7,480) $ 5,159 1.69 Prepay Accounts Payable $ 8,789 (3,630) $ 5,159 2.42
Payment of the accounts payable does not affect working capital, but does improve the current ratio. Is this balance sheet "window dressing" worth the opportunity cost of not being able to invest the cash? Remember, once the payment is made, the cash is in someone elses hands. b. Current assets......................................... - Current liabilities. .................................... = Working capital. .................................... = Current ratio.......................................... Without Loan $ 12,639 (7,480) $ 5,159 1.69 With Loan $ 17,639 (12,480) $ 5,159 1.41
If the loan is taken after the end of the fiscal year, the current ratio on the year-end balance sheet will be higher than if the loan is taken before the end of the year. Working capital is not affected. Thus, it makes sense to wait until after the end of the year to borrow on a short-term basis, unless cash is needed immediately. E3-10. a. 1.8 Current ratio = (Current assets / $68,700 Current liabilities) Current assets = $123,660 Working capital = $123,660 Current assets - $68,700 Current liabilities = $54,960 b. Both current assets and current liabilities would be $15,300 greater at November 30, if the payment on November 29 had not been made. Working capital = $138,960 - $84,000 = $54,960 Current ratio = $138,960 / $84,000 = 1.65 c. Working capital at November 30 is not affected because both current assets and current liabilities would increase by the same amount (had the $15,300 payment not been made on November 29). However, the current ratio was increased (from 1.65 to 1.8) as a result of the payment because the proportion of current assets to current liabilities changed. When the current ratio is greater than 1.0, payments of accounts payable increase the ratio because the denominator is decreased proportionately more than the numerator is decreased.
Fundamental Interpretations Made from Financial Statement Data P3-11. a. ROI = Margin * Turnover = (Net income / Net revenues) * (Net revenues / Average total assets) = ($7,314 / $29,389) * ($29,389 / (($31,471 + $43,849) / 2)) = (24.9% Margin * 0.78 Turnover) = 19.4% b. ROE = Net income / Average stockholders' equity = $7,314 / (($23,377 + $32,535) / 2) = 26.2% c. Working capital = Current assets - Current liabilities 12/25/99 12/26/98 Current assets................................................................. $17,819 $13,475 - Current liabilities.................................................................. (7,099) (5,804) = Working capital............................................................... $10,720 $ 7,671 d. Current ratio = Current assets / Current liabilities 12/25/99 12/26/98 Current assets................................................................. $17,819 $13,475 / Current liabilities.................................................................. (7,099) (5,804) = Current ratio................................................................... 2.51 2.32
3-11. (continued) e. Acid-test ratio = (Cash + Short-term securities + Accounts and Notes receivable) Current liabilities 12/25/99 12/26/98 Cash and cash equivalents.............................................. $ 3,695 $ 2,038 Short-term investments................................................... 7,705 5,272 Trading assets................................................................. 388 316 Accounts receivable, net. ................................................ 3,700 3,527 Total (quick assets)......................................................... $15,488 $11,153 Total (quick assets)......................................................... / Current liabilities ............................................................ = Acid-test ratio................................................................. $15,488 7,099 2.18 $11,153 5,804 1.92
P3-12. a. ROI = Margin * Turnover = (Net income / Sales) * (Sales / Average total assets) = ($34,000 / $580,000) * (($580,000 / ($280,000 + $312,000) / 2) = (5.86% Margin * 1.959 Turnover) = 11.5% b. ROE = Net income / Average owners' equity
Chapter 3 = $34,000 / (($167,000 + $196,000) / 2) = 18.7% c. Working capital = $202,000 Current assets - $94,000 Current liabilities = $108,000 d. Current ratio = ($202,000 Current assets / $94,000 Current liabilities) = 2.15 e. Acid test ratio = (Cash + Accounts receivable) / Current liabilities = ($21,000 + $78,000) / $94,000 = 1.05 f. Solution approach: Think about the effects of this entry on the balance sheet, then indicate the impact of these effects on the respective ratios as either increase, decrease, or no effect. Finally, explain why each ratio is affected in the way that it is by reference to the impact on the numerator and denominator of each ratio. ROI for the year ended December 31, 2002: Increase. The payment of an account payable decreases current liabilities and also decreases current assets. This entry has no impact on the income statement, so the numerator of the ROI calculation (net income) is unaffected. However, now having P3-12. f. (continued) less cash, Hames would also have a lower average total assets in the denominator of the ROI calculation. (Average total assets decrease from $296,000 to $288,500, thus causing the ratio to increase from 11.49% to 11.78%.) ROE for the year ended December 31, 2002: No effect. In this case, both the numerator and the denominator are unaffected by the entry. Average owners equity does not change when an account payable is paid off only current assets and current liabilities are affected. Working capital as at December 31, 2002: No effect. Since working capital is the difference between current assets and current liabilities, a decrease of $15,000 to each category will have no effect on the net amount. Current ratio as at December 31, 2002: Increase. So long as the current ratio is greater than 1.0 to begin with, then the proportionate amount of current assets relative to current liabilities will increase as each category is decreased by an equal dollar amount. In this case the current ratio would increase from 2.15 to 2.37. g. Solution approach: Same as part f above: ROI for the year ended December 31, 2002:
Fundamental Interpretations Made from Financial Statement Data No effect. The collection of an account receivable increases one current asset and decreases another current asset. This entry has no effect on either net income or average total assets. ROE for the year ended December 31, 2002: No effect. This entry has no effect on either net income or average owners equity. Working capital as at December 31, 2002:
No effect. Although the composition of current assets changed (i.e., more cash and less accounts receivable), total current assets remained the same, and current liabilities are unaffected by the collection of accounts receivable. Current ratio as at December 31, 2002: No effect. No change in total current assets or total current liabilities. P3-13. a. Working capital = Current assets - Current liabilities 1/31/02 1/31/01 Current assets. ......................................................................... $ 14 - Current liabilities.................................................................................. (6) $ 12 Current ratio = Current assets / Current liabilities 1/31/02 1/31/01 Current assets. ......................................................................... $ 14 / Current liabilities.................................................................................. 6 = Current ratio............................................................................ 1.56 3.0 b. Even though the firm has more cash at January 31, 2002, it is less liquid based on the working capital and current ratio measures. The firm owes more on accounts payable, and has less inventory to sell and fewer accounts receivable to collect, as compared to January 31, 2001. c. Accounts receivable were collected, inventories were reduced, and current liabilities increased. These changes and the increase in cash are all possible, because changes in a firm's cash position and its profitability are not directly related. P3-14. a. Current ratio = Current assets / Current liabilities 8/31/02 8/31/01 $ 18 9 = Working capital................................................................................... $ 18 (9) $5
Chapter 3 Current assets. ......................................................................... $ 41 / Current liabilities.................................................................................. 29 = Current ratio............................................................................ Working capital = Current assets - Current liabilities 8/31/02 8/31/01 Current assets. ......................................................................... $ 41 - Current liabilities.................................................................................. (29) $3 b. Although both the current ratio and working capital at August 31, 2002 are greater than at August 31, 2001, the firm has less cash and marketable securities at the later date. Accounts receivable and inventories have increased substantially (from $16 to $31), and these amounts may not be readily convertible to cash. Thus, in some ways, the firm is actually less liquid at August 31, 2002 than it was at August 31, 2001. = Working capital................................................................................... $ 32 (22) $19 1.86 1.1 $ 32 22
P3-15. a. 15% ROI = (Margin * 2.0 Turnover) Margin required as a manufacturer = 7.5% 2.0 Turnover = (Sales / $6,000,000 Average total assets) Sales required as a manufacturer = $12,000,000 7.5% Margin = (Net Income / $12,000,000 Sales) Net Income required as a manufacturer = $900,000 (or $0.9 million) b. 15% ROI = (Net Income / $1,000,000 Average total assets) Net Income required as a service firm = $150,000 15% ROI = (2.5% Margin * Turnover) Turnover required as a service firm = 6.0 6.0 Turnover = (Sales / $1,000,000 Average total assets) Sales required as a service firm = $6,000,000 (or $6 million) P3-16. a. ROI = (32% Margin * 0.4 Turnover) = 12.8% 0.4 Turnover = (Sales / $800,000 Average total assets) Sales = $320,000 b. 12.8% ROI = (20% Margin * Turnover)
Fundamental Interpretations Made from Financial Statement Data Turnover = 0.64 0.64 Turnover = (Sales / $800,000 Average total assets) Sales = $512,000 c. If margin were reduced from 32% to 20% via the price lowering strategy, sales would have to increase by $192,000 (from $320,000 to $512,000) for Charlie to earn the same 12.8% ROI. This represents a 60% increase over the original sales volume, which is not quite as bad as Charlie makes it sound, but his point is certainly well taken. d. By increasing marketing efforts (i.e., kicking off a new advertising campaign, or conducting more extensive market research), Charlie would also be increasing the operating expenses of his business, which would reduce margin. However, successful marketing efforts are likely to increase sales volume enough to cause the resulting increase in turnover to more than offset the decrease in margin. As a result, ROI would be likely increase.
3-16. d. (continued)
Solution approach: The following strategies may be worth considering for a "highprice, high-service" retail furniture store when faced with new competition:
Reduction in inventory carrying costs via careful screening of existing inventory. For a furniture store, the inventory available for sale and the building the store is located in are normally the largest assets on the balance sheet. In the short-term, there is probably not much that Charlie can do to control building occupancy costs. However, if Charlie were to concentrate his inventory to those areas that generate the highest margins and/or highest turnover, this may allow him to substantially reduce average total assets. By reducing average assets, turnover increases, thereby increasing ROI. An important point to remember when considering the DuPont model of ROI analysis is that asset utilization (i.e., turnover) is just as important as generating high profit margins. Labor saving strategies might also be worth considering. Although the problem does not give much information to work from, one might infer that a "high service" furniture store would be likely to have a large sales force relative to its total floor space. If this were the case, then Charlie might benefit by restructuring his sales force (i.e., pay based on commissions only, and/or reducing staff numbers during non-peak hours). If this could be done without compromising Charlie's "high service" competitive advantage (i.e., no sales lost due to "lower service"), then the labor cost savings would increase the company's margin, and thereby increase ROI. 1999 1998
C3-17. a.
Chapter 3 Cash and cash equivalents.................................................................. $ 3,345 $ 1,453 Short-term investments.................................................................. 699 171 Accounts receivable, net................................................................ 5,125 5,057 Total quick assets for acid-test ratio (A)............................................ $ 9,169 $ 6,681 Inventories. .................................................................................... 3,422 3,745 Deferred income taxes................................................................... 3,162 2,362 Other current assets....................................................................... 750 743 Total current assets (B).................................................................. $16,503 $ 13,531 Notes payable and current portion of long-term debt.................... $ 2,504 Accounts payable........................................................................... 3,015 Accrued liabilities........................................................................... 6,897 Total current liabilities (C). ............................................................ $12,416 C3-17 a. (continued) Working capital (B C)................................................................. $ 4,087 Current ratio (B / C)...................................................................... 1.33 Acid-test ratio (A / C).................................................................... 0.74 b. Common stock............................................................................... $ 1,838 Additional paid-in capital............................................................... 2,572 Retained earnings........................................................................... 8,780 Non-owner changes to equity........................................................ 3,154 Total stockholders equity.............................................................. $16,344 ROE = Net earnings (loss) / Average stockholders equity 1999 = $817 / (($12,222 + $16,344) / 2) = 5.7% 1998 = $962 / (($13,272 + $12,222) / 2) = 7.5% c. ROI = Margin * Turnover = (Net earnings (loss) / Net sales) * (Net sales / Average total assets) 1999 = ($817 / $30,931) * ($30,931 / (($28,728 + 37,327) / 2)) = (2.6% Margin * 0.94 Turnover) = 2.5% ROI 1998 = ($962 / $29,398) * ($29,398 / (($27,278 + $28,728) / 2)) = (3.3% Margin * 1.05 Turnover) = 3.4% ROI d. Motorolas liquidity is not a big concern, especially in 1999. With working capital of more than $4 billion as at December 31, 1999, the relatively low current ratio and acid- test ratio probably reflect the companys efforts to minimize the investment in accounts receivable and inventory, respectively, in favor of assets that are more likely to generate a higher ROI in the future (such as property, plant, and $ 2,091 1.18 0.58 $ 1,804 1,894 8,254 270 $12,222 $ 2,909 2,305 6,226 $ 11,440
Fundamental Interpretations Made from Financial Statement Data equipment). Motorolas profitability is of much greater concern. Since 1998 was a loss year, it is difficult to properly assess Motorolas profitability for the two-year period. An ROI of 2.5% (in 1999) is certainly on the low end for a major corporation, although this may reflect the fact that the company was coming off a loss year. To make a more complete assessment, it would be appropriate to look at the trend of ROI for Motorola as compared to the telecommunications industry trend for at least 5 years.
C3-17. d. (continued) Notice that ROE was significantly higher than ROI in 1999, which indicates that the company is making effective use of borrowed fundsthat is, the company is using borrowed funds to increase the return to its owners. However, ROE was significantly lower than ROI in 1998, which indicates that in a loss year, the use of borrowed funds works against the interest of the company stockholders. (The idea of financial leverage will be introduced in Chapter 7 and expanded upon in Chapter 11.) e. Margin, or profit margin.
f.
Solution approach: Determine the differences between ROI and return on average invested capital for each year, and then discuss possible explanations of the observed differences. The differences to be explained are: ROI (as calculated in part c) ............ .............................................. Return on average invested capital (as presented by Motorola)...... 1999 2.5% 5.5% 1998 3.4% 6.2%
What might explain these differences? We cant know for sure, because the details of Motorolas calculation were not disclosed, but here are some educated guesses: 1. One possibility would be the way in which invested capital is calculated by Motorola as compared to the way average total assets is calculated in ROI. It is unlikely that this would explain the fact that Motorolas results are nearly twice as large as those calculated for ROI. However, it is very possible that Motorola does not consider the other assets included on their balance sheet in the calculation of invested assets. Please see other assets on the balance sheet. If $11,578 (for 1999) and $5,148 (for 1998) were to be excluded from the average total assets calculation for the 1999 ROI calculation in part c above, the following result would occur: ROI = Net earnings / Average total assets (excluding other assets) 1999 = ($817 / (($28,728 $5,148 + $37,327 $11,578) / 2)) = ($817 / $24,664.5) = 3.3% ROI
Chapter 3 Thus, ROI would increase in 1999 from 2.5% to only 3.3%, so there must be something else going on.
C3-17. (continued) f 2. A more likely explanation would be in the way Motorola defines return as compared to the net earnings figure used in the ROI calculation. Motorola may return in the numerator as operating income or possibly pretax income or some other income statement subtotal. If operating income (rather than net earnings) were to be used in the 1999 ROI calculation in part c above, the following result would occur: ROI = Operating income / Average total assets (excluding other assets) 1999 = ($1,323 / (($28,728 $5,148 + $37,327 $11,578) / 2)) = ($1,323 / $24,664.5) = 5.4% This ROI gets us much closer to Motorolas reported result of 5.5%. Undoubtedly, there are many other possible explanations for the differences observed. Perhaps Motorola used a more refined measure of average total assets (i.e., average monthly assets). Similar adjustments could be made using the 1998 ROI data as a starting point, but we would need to know how much other assets were as at December 31, 1997 to make the adjustments properly. g. The differences to be explained are: ROE (as calculated in part b)........... .............................................. Return on average stockholders equity (as presented by Motorola) 1999 5.7% 5.9% 1998 7.5% 7.6%
In this situation with much smaller differences to explain, it is unlikely that there are significant variations in the numerator. The observed differences probably relate to the way in which average stockholders equity is calculated in the denominator (Motorolas calculation is likely to be based upon more precise data). h. Although different investors may view these trends in different ways (depending on their investment objectives), the following observations can be observed: 1. Year-end employment: This peaked at 150,000 in 1997, and dropped significantly in 1998 and 1999. Given Motorolas poor earnings performance during these same years, an average investor is likely to view this trend favorably. Downsizing efforts, when properly managed, often lead to greater profitability in future years.
Fundamental Interpretations Made from Financial Statement Data C3-17. (continued) h. 2. Capital expenditures: As a percentage of sales, capital expenditures are generally decreasing over time, which is not normally considered a healthy sign for a company having strong growth prospects. Since sales have been relatively flat since 1998 (see the income statement data), this would be an even greater concern for an investor who was looking for long-term value. To make a proper analysis of the trend, you would need to consider the companys sales growth during the 5-year period, as well as the actual dollar amounts spent on capital expenditures, and the extent to which the reduction in capital expenditures relates to company-wide policy decisions (i.e., it may well be related to an overall downsizing plan). 3. Research and development: As a percentage of sales, R & D expenditures are generally increasing over time, which is normally considered a healthy sign for a company having strong growth prospects. At first, this may seem a little strange, given that the trend in capital expenditures is moving in the opposite direction. Yet, perhaps it can be explained as an effort on behalf of senior management to make better utilization of existing facilities and technologies a recommitment to the companys core competencies without over-expanding in terms of physical resources. i. When analyzing the future growth prospects of most companies, investors would look most closely at profitability measures, such as the first three items listed. Net earnings as a percent of sales is a measure of margin. Return on average invested capital is essentially a measure of ROI. Both of these measures are important to the average investor. In a single measurement, however, ROE gives an investor the most direct and meaningful feedback about the companys performance in terms of their own investment. For companies (such as Motorola) in high-tech industries, growth-oriented investors would also be concerned about trends in R & D, capital expenditures, employment because these are all indicators of the companys ability to survive in an increasingly competitive global environment. Yet, ROE is the single best measure to an investor. j. Solution Approach: A prudent investor would be wise to take the following factors into consideration before choosing between alternative investment opportunities: 1. What is the relative risk of the investment? In this case, although Motorolas common stock is considered a blue-chip investment, an investor would be interested in knowing how investment analysts regard the potential risks/rewards of ownership.
C3-17. (continued) j. 2. How does an investment in Motorolas common stock "fit" within the investor's overall
Chapter 3 portfolio? The text does not cover Modern Portfolio Theory or similar "Finance" topics, but it is worth noting that individual investments must be considered within the context of the investor's overall portfolio. An investment in Company X that may appear to be "too risky" when analyzed in isolation, but it may in fact be risk-reducing and returnenhancing when viewed as "part of" an investor's overall portfolio. 3. How does an investment in Motorolas common stock fit within the investor's investing objectives? Different people invest for different reasons. A young couple in their 20's or 30's may wish to save for their retirement or for the college education of their children. As such, they would be more inclined to invest in a "growth" portfolio than would be a couple in their 60's or 70's who would be more likely to invest in an "income" oriented portfolio. 4. Additional historical data concerning Motorola and its industry would be helpful in making a more complete trend analysis. These data might include line-item details from Motorolas past income statements, as well as cash flows data, dividends data, and stock price data. 5. An understanding of current events surrounding the company and its industry, as well as an understanding of general economic conditions at the time of the proposed investment. C3-18. a. 1999 1998 Cash and cash equivalents...................................................... $1,127,654 $1,169,810 Marketable securities........................................................... 208,717 158,657 Accounts receivable, net...................................................... 646,339 558,851 Total quick assets for acid-test ratio (A)................................ $1,982,710 $1,887,318 Inventory.............................................................................. 191,870 167,924 Other current assets. ............................................................ 522,225 172,944 Total current assets (B)........................................................ $2,696,805 $2,228,186 Current maturities of long-term obligations......................... $ 5,490 $ 11,415 Accounts payable................................................................. 898,436 718,071 Accrued liabilities................................................................. 609,132 415,265 Accrued royalties ................................................................ 153,840 167,873 Other current liabilities........................................................ 142,812 117,050 Total current liabilities (C)................................................... $1,809,710 $1,429,674 Working capital (B C)....................................................... $ Current ratio (B / C) ............................................................ Acid-test ratio (A / C).......................................................... C3-18. (continued) b. Common stock and additional paid-in capital...................... Retained earnings................................................................. Other stockholders equity................................................... Total stockholders equity.................................................... 1999 1998 $ 660,070 $ 367,552 1,408,852 980,908 (51,804) (4,085) $2,017,118 $1,344,375 887,095 $ 798,512 1.49 1.56 1.10 1.32
Fundamental Interpretations Made from Financial Statement Data ROE = Net income / Average stockholders equity 1999 = $427,944 / (($1,344,375 + $2,017,118) / 2) = 25.5% 1998 = $346,399 / (($930,044 + $1,344,375) / 2) = 30.5% c. ROI = Margin * Turnover = (Net income / Net sales) * (Net sales / Average total assets) 1999 = ($427,944 / $8,645,561) * ($8,645,561 / (($2,890,380 + $3,954,688) / 2)) = (4.9% Margin * 2.53 Turnover) = 12.5% ROI 1998 = ($346,399 / $7,467,925) * ($7,467,925 / (($2,039,271 + $2,890,380) / 2)) = (4.6% Margin * 3.03 Turnover) = 14.1% ROI d. Gateways liquidity ratios have been well managed, and are not of great concern. Working capital expanded during 1999, especially with respect to other current assets. Gateways profitability has been excellent! Gateways ROE was significantly higher than ROI during both years, which indicates that the company is making effective use of borrowed funds that is, the company is using borrowed funds to increase the return to its owners. (The idea of financial leverage will be introduced in Chapter 7 and expanded upon in Chapter 11.) In Gateways case, nearly all of the companys liabilities are current, and non-interest bearingwhich effectively means that the company is able to borrow money for free and then put it to use to enhance their stockholders ROE. e. If stockholders were to have received dividends from Gateway, they would not have been likely to earn an ROE of 25.5% in 1999, or 30.5% in 1998, by investing in other firms. Thus, stockholders of highly profitable firms such as Gateway, Inc., are not inclined to place strong dividend pressures on the board of directors because the firm does a better job managing their investment than they could do themselves. This is especially true if the firm can further enhance their ROE through the positive use financial leverage. Many stockholders also wish to avoid the tax consequences of current dividends, and C3-18. e. (continued) generally favor growth stocksbut the primary reason is that Gateway can make their investment grow rapidly, via stock price appreciation. The following note was disclosed in Gateways 1999 annual report: Gateway management believes the best use of retained earnings is to fund internal growth and for general corporate purposes. As a result, Gateway has not declared any cash dividends on Common Stock since it was first publicly registered and does not anticipate paying any cash dividends on Common Stock in the foreseeable future. f. Yes, the net sales, net income, and total assets trends show great consistency from 1995
Chapter 3 through 1999. The big picture is that the company has grown rapidly and consistently during this period. Although net income was down in 1997, the upward trend continued in 1998 and 1999. The long-term obligations trend is not very meaningful because the amounts involved are immaterial for all years presented. g. Each of the first three trends would be meaningful to investors, in that they express important growth patterns. Most investors tend to focus on sales growth or earnings growth as opposed to asset growth because asset growth is sometimes financed by debt. Thus, income statement measures tend to be better predictors of the future. Since sales growth patterns are likely to be more stable than earnings growth patterns (i.e., less likely to exhibit wild swings from year to year), the trend in net sales is arguably the most appropriate one for investors to focus on. The long-term obligations trend is the least relevant in this case because the amounts are immaterial. h. Solution Approach: A prudent investor would be wise to take the following factors into consideration before choosing between alternative investment opportunities: 1. What is the relative risk of the investment? In this case, although Gateways common stock may be considered an excellent investment, an investor would be interested in knowing how investment analysts regard the potential risks/rewards of ownership. 2. How does an investment in Gateways common stock "fit" within the investor's overall portfolio? The text does not cover Modern Portfolio Theory or similar "Finance" topics, but it is worth noting that individual investments must be considered within the context of the investor's overall portfolio. An investment in Company X that may appear to be "too risky" when analyzed in isolation, but it may in fact be risk-reducing and return-enhancing when viewed as "part of" an investor's overall portfolio.
C3-18. (continued) h. 3. How does an investment in Gateways common stock fit within the investor's investing objectives? Different people invest for different reasons. A young couple in their 20's or 30's may wish to save for their retirement or for the college education of their children. As such, they would be more inclined to invest in a "growth" portfolio than would be a couple in their 60's or 70's who would be more likely to invest in an "income" oriented portfolio. 4. Additional historical data concerning Gateway and its industry would be helpful in making a more complete trend analysis. These data might include line-item details from Gateways past income statements, as well as cash flows data, dividends data, and stock price data. 5. An understanding of current events surrounding the company and its industry, as well as an understanding of general economic conditions at the time of the investment.
Fundamental Interpretations Made from Financial Statement Data C3-19. a. PepsiCo 1999 1998 Cash and cash equivalents.................................................................. $ 964 $ 311 Short-term investments, at cost.... ................................................ 92 83 Accounts and notes receivable, net............................................... 1,704 2,453 Total quick assets for acid-test ratio (A)...................................... $2,760 $2,847 Total current assets (B)................................................................. 4,173 4,362 Total current liabilities (C)................................................ 3,788 7,914 Working capital (B C)............................................................... $ 385 Current ratio (B / C)............................................................... 1.10 0.55 Acid-test ratio (A / C).................................................................. 0.73 Coca-Cola 1999 Cash and cash equivalents........................................................... $1,611 Marketable securities................................................................... 201 Trade accounts receivable, net..................................................... 1,798 Total quick assets for acid-test ratio (A)...................................... $3,610 Total current assets (B)................................................................ 6,480 Total current liabilities (C)........................................................... 9,856 Working capital (B C).............................................................. $(3,376) Current ratio (B / C)............................................................... 0.66 0.74 Acid-test ratio (A / C)................................................................. 0.37 C3-19. b. ROE = Net income / Average stockholders equity $(3,552) 0.36 1998 $1,648 159 1,666 $3,473 6,380 8,640 $(2,260) 0.40
PepsiCo 1999 1998 Net income (A)........................................................................... $2,050 $1,993 Beginning stockholders equity.......................................................... 6,401 6,936 Ending stockholders equity........................................................ 6,881 6,401 Average stockholders equity (B).................................... 6,641 6,668 ROE (A / B).. ......................................................................... 30.9% 29.9% Coca-Cola 1999 1998 Net income (A)........................................................................... $2,431 $3,533 Beginning stockholders equity.......................................................... 8,403 7,274 Ending stockholders equity........................................................ 9,513 8,403 Average stockholders equity (B).................................... 8,958 7,838 ROE (A / B).. ......................................................................... 27.1% 45.1% c. ROI = Margin * Turnover = (Net income / Net sales) * (Net sales / Average total assets) PepsiCo 1999 1998 Net income (A)........................................................................... $ 2,050 $ 1,993 Net sales (B)............................................................................... 20,367 22,348 Beginning total assets................................................................. 22,660 20,101
Chapter 3 Ending total assets...................................................................... Average total assets (C). ............................................................. Margin (A / B)............................................................................ Turnover (B / C)......................................................................... ROI (A / C) or (Margin * Turnover).......................................... 17,551 20,105 10.2% 1.01 10.2% 22,660 21,380 8.9% 1.05 9.3%*
Coca-Cola 1999 1998 Net income (A)........................................................................... $ 2,431 $ 3,533 Net sales (B)........................................................................... 19,805 18,813 Beginning total assets................................................................. 19,145 16,881 Ending total assets...................................................................... 21,623 19,145 Average total assets (C). ............................................................. 20,384 18,013 Margin (A / B)............................................................................ Turnover (B / C)......................................................................... ROI (A / C) or (Margin * Turnover).......................................... 12.3% 0.97 11.9% 18.8% 1.04 19.6%*
* The ROI results using (Margin * Turnover) may be off slightly due to the rounding errors.
C3-19. (continued) d. Solution approach: Determine the differences for each year between ROI and return on capital, and then discuss possible explanations of the observed differences. The differences to be explained are: ROI (as calculated in part c)....... .............................................. Return on capital (as presented by Coca-Cola). ......................... 1999 11.9% 18.2% 1998 19.6% 30.2%
What might explain these differences? We cant know for sure, because the details of Coca-Colas calculation were not disclosed, but here are some educated guesses: 1. One possibility would be the way in which capital is calculated by Coca-Cola as compared to the way average total assets is calculated in ROI. It is unlikely that this would explain all of the differences observed above looking at the line-item details on Coca-Colas balance sheet, there are few, if any, assets that would not be considered as part of the companys invested capital. Coca-Cola may be excluding Investments in unconsolidated subsidiaries from its definition of invested capital. If this were the case, the company should also exclude the Equity income (loss) from its definition of return. 2. A more likely explanation would be in the way Coca-Cola defines return as compared to the net income figure used in the ROI calculation. Coca-Cola may define return in the numerator as operating income or possibly income before income taxes or some other income statement subtotal. If operating income (rather than net income) were to be used in the ROI calculations in part c above,
Fundamental Interpretations Made from Financial Statement Data the following results would occur: Coca-Cola 1999 Operating income....................................................................... $ 3,982 Average total assets................................................................ 20,384 18,013 ROI......... .................................................................................. 19.5% 1998 4,967 27.6%
This gets closer to Coca-Colas reported results, but 27.6% falls short of the mark in 1998 and 19.5% exceeds the mark in 1999. Obviously, this cannot be the complete explanation the key point is that the definitions need to be understood if the ratio results are to be evaluated sensibly.
C3-19. (continued) e. The accounting for discontinued business operations is discussed briefly in Chapter 9. For purposes of evaluating income statement trends, the key point is that the line-item effects of discontinued operations are removed from the income statements of all prior years that are shown for comparison purposes. In the year the restaurants were sold (1997) PepsiCo reported income from discontinued operations, net of tax of $651 million, which increased the net income figure to a much higher amount (in 1997) than would have been the case had the restaurants segment not been sold. Since the timing of such transactions is within the control of management, the net of tax amount must be reported on the face of the income statement had PepsiCo waited until 1998 to sell the restaurants segment, the gain could have been shifted to that year. As a result, most investors would consider the trend in PepsiCos income from continuing operations for the period from 1997 through 1999 to be more meaningful than the trend in net income for this same period. f. Liquidity: Based only on the results calculated in part a, its difficult to say that either company maintains sufficient levels of liquidity. Both companies routinely operate their core businesses on negative working capital positions. Likewise, the current ratio and acid-test ratio results are far below the levels that would traditionally be considered prudent. Yet, both companies are highly successful and operate in a global marketplace. Both companies have world-class cash management systems, including ready access to significant lines of credit. The likelihood that either company will have a serious problem meeting its current obligations (such as payroll) is minimal. This case proves our point that as a rule of thumb, you should not place much reliance on rules of thumb. Profitability: Earnings were excellent for both companies during 1998 and 1999. As expressed in ratio form, all signs are good, and it would be difficult to choose between the two companies on the basis of profitability measures alone.
Chapter 3 Coca-Cola had an amazing year in 1998, with an ROE of 45.1% and an ROI of 19.6% (more than twice that of PepsiCos 1998 ROI of 9.3%). Coca-Cola also outperformed PepsiCo in 1999, as measured by ROI yet, PepsiCos 1999 ROE was higher. CocaCola has perhaps earned a slight edge in terms of overall profitability, but turnover for both companies hovered around 1.0, meaning that asset utilization differences were not significant.
C3-19. (continued) g. Solution Approach: A prudent investor would be wise to take the following factors into consideration before choosing between alternative investment opportunities: 1. What is the relative risk of each investment? In this case, a common stock investment in either company would be considered blue chip, so an investor would be interested in knowing how investment analysts regard each companys future earnings and cash flows prospects. 2. How does an investment in the common stock of either company "fit" within the investor's overall portfolio? The text does not cover Modern Portfolio Theory or similar "Finance" topics, but it is worth noting that individual investments must be considered within the context of the investor's overall portfolio. An investment in Company X that may appear to be "too risky" when analyzed in isolation, but it may in fact be risk-reducing and return-enhancing when viewed as "part of" an investor's overall portfolio. 3. How does an investment in either companys stock fit within the investor's investing objectives? Different people invest for different reasons. A young couple in their 20's or 30's may wish to save for their retirement or for the college education of their children. As such, they would be more inclined to invest in a "growth" portfolio than would be a couple in their 60's or 70's who would be more likely to invest in an "income" oriented portfolio. 4. Additional historical data concerning both companies and the soft-drink industry would be helpful in making a more complete trend analysis. These data might include lineitem details from each companys past income statements, as well as cash flows data, dividends data, and stock price data. 5. An understanding of current events surrounding each company and the industry, as well as an understanding of general economic conditions at the time of the investment.
Fundamental Interpretations Made from Financial Statement Data
TAKE-HOME QUIZ CHAPTER 3 NAME______________________ Attached are the financial statements and the ___-year summary from the 20__ Annual Report of ______________________________. REQUIRED: 1. Calculate ROI, showing margin and turnover, for 20__, 20__, and 20__. 2. Calculate the company's working capital, current ratio, and acid-test ratio at [balance sheet dates]. 3. Calculate ROE for as many of the past three years as you can. 4. Assume that you have $1,000 that you would like to invest in the common stock of a company. Evaluate the common stock of ______________________________ as a potential investment. From the data available on the attached financial statements, identify the five most important criteria that you would use to make your investment decision, and explain why each is important.
Instructors Note: Use or adapt these questions for an annual report (or set of financial statements) that you provide to the students.