ANALYSIS
LEARNING
LG1
Review CHAPTER
2
FINANCIAL
STATEMENTS
AND the contents of the stockholders report
and the procedures for consolidating international
financial statements.
LG2
Understand who uses financial ratios, and
how.
LG3
LG5
LG6
GOALS
Use ratios to analyze a firms profitability and its
market value.
Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
Use ratios to analyze a firms liquidity and
activity.
LG4
Discuss the relationship between debt and
financial leverage and the ratios used to analyze
a firms debt.
Across the Disciplines WHY THIS CHAPTER MATTERS TO YO U
Accounting: You need to understand the stockholders report
and preparation of the four key financial statements; how firms
consolidate international financial statements; and how to calculate and interpret financial ratios for decision making.
Information systems: You need to understand what data are
included in the firms financial statements in order to design
systems that will supply such data to those who prepare the
statements and to those in the firm who use the data for ratio
calculations.
Management: You need to understand what parties are interested in the annual report and why; how the financial statements will be analyzed by those both inside and outside the firm
to assess various aspects of performance; the caution that
40
should be exercised in using financial ratio analysis; and how
the financial statements affect the value of the firm.
Marketing: You need to understand the effects your decisions
will have on the financial statements, particularly the income
statement and the statement of cash flows, and how analysis of
ratios, especially those involving sales figures, will affect the
firms decisions about levels of inventory, credit policies, and
pricing decisions.
Operations: You need to understand how the costs of operations are reflected in the firms financial statements and how
analysis of ratios, particularly those involving assets, cost of
goods sold, or inventory, may affect requests for new equipment or facilities.
HOME DEPOT
BUILDING STRONG
FINANCIALS
inancial reporting is no longer the primary responsibility of the chief financial officer (CFO). The
role of todays CFO, a key member of the executive team, has broadened to include strategic
planning and, at many companies, information management. Managing a companys financial
operations takes many different skills. Financial planning, operations, and analysis; treasury operations (raising funds and managing cash); business acquisition and valuation; tax planning; and
investor relations are also under his or her control.
Home Depot CFO and treasurer Carol Tom reports directly to chief executive officer Robert
L. Nardelli. She works closely with him and with Dennis J. Carey, an executive vice president and
the chief strategy officer, to guide the giant home improvement retailers future growth. Along
with her strategic responsibilities, Tom chooses the key financial measurements on which she
wants managers to focus. These are tied to the economic climate. When the economy was
strong, her objective was improving the companys return on investment (ROI). By late 2001, Home
Depots ROI was 16.0 percent, compared to 14.7 percent for the home improvement retail industry,
6.7 percent for the services sector, and 10.2 percent for the S&P 500.
In 2001s slower economy, the emphasis shifted to activity ratios that measure how quickly
accounts are converted into cash. Particularly important to a retail chain are inventory turnover,
receivables collection period, and accounts payable periods. Home Depot hired consultants to
benchmark its financial operations with other best-in-class companies. Were looking for processing efficiencies, Tom says. Improved new-store productivity and lower pre-opening costs
per store, together with attention to cost control, are boosting margins. In the third quarter of
2001, when many companies reported earnings drops, Home Depots net income and earnings per
share rose over the same period in 2000.
The companys measures of debt also indicate a strong financial position. Its ratio of debt to
total capital indicates that only about 10 percent of its total long-term financing is debt, a very low
degree of indebtedness. This strong position gives Home Depot more flexibility to pursue new
projects, such as its new high-end line of stores called Expo, and more opportunities to raise
funds from banks, which use ratio analysis to assess creditworthiness.
In this chapter you will learn how to analyze financial statements using financial ratios.
F
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PART 1
Introduction to Managerial Finance
LG1
2.1 The Stockholders Report
generally accepted
accounting principles (GAAP)
The practice and procedure
guidelines used to prepare and
maintain financial records and
reports; authorized by the
Financial Accounting Standards
Board (FASB).
Financial Accounting
Standards Board (FASB)
The accounting professions
rule-setting body, which
authorizes generally accepted
accounting principles (GAAP).
Securities and Exchange
Commission (SEC)
The federal regulatory body that
governs the sale and listing of
securities.
Every corporation has many and varied uses for the standardized records and
reports of its financial activities. Periodically, reports must be prepared for regulators, creditors (lenders), owners, and management. The guidelines used to prepare and maintain financial records and reports are known as generally accepted
accounting principles (GAAP). These accounting practices and procedures are
authorized by the accounting professions rule-setting body, the Financial
Accounting Standards Board (FASB).
Publicly owned corporations with more than $5 million in assets and 500 or
more stockholders1 are required by the Securities and Exchange Commission
(SEC)the federal regulatory body that governs the sale and listing of securitiesto provide their stockholders with an annual stockholders report. The
annual report summarizes and documents the firms financial activities during the
past year. It begins with a letter to the stockholders from the firms president
and/or chairman of the board.
The Letter to Stockholders
stockholders report
Annual report that publicly
owned corporations must provide
to stockholders; it summarizes
and documents the firms
financial activities during the
past year.
WW
W
The letter to stockholders is the primary communication from management. It
describes the events that are considered to have had the greatest impact on the
firm during the year. It also generally discusses management philosophy, strategies, and actions, as well as plans for the coming year. Links at this books
Web site (www.aw.com/gitman) will take you to some representative letters to
stockholders.
letter to stockholders
Typically, the first element of the
annual stockholders report and
the primary communication from
management.
The Four Key Financial Statements
The four key financial statements required by the SEC for reporting to shareholders are (1) the income statement, (2) the balance sheet, (3) the statement of
retained earnings, and (4) the statement of cash flows.2 The financial statements
from the 2003 stockholders report of Bartlett Company, a manufacturer of
metal fasteners, are presented and briefly discussed.
Income Statement
income statement
Provides a financial summary of
the firms operating results
during a specified period.
The income statement provides a financial summary of the firms operating results
during a specified period. Most common are income statements covering a 1-year
period ending at a specified date, ordinarily December 31 of the calendar year.
1. Although the Securities and Exchange Commission (SEC) does not have an official definition of publicly owned,
these financial measures mark the cutoff point it uses to require informational reporting, regardless of whether the
firm publicly sells its securities. Firms that do not meet these requirements are commonly called closely owned
firms.
2. Whereas these statement titles are consistently used throughout this text, it is important to recognize that in practice, companies frequently use different titles. For example, General Electric uses Statement of Earnings rather
than Income Statement and Statement of Financial Position rather than Balance Sheet. Bristol Myers Squibb
uses Statement of Earnings and Retained Earnings rather than Income Statement. Pfizer uses Statement of
Shareholders Equity rather than Statement of Retained Earnings.
CHAPTER 2
Hint Some firms, such as
retailers and agricultural firms,
end their fiscal year at the end
of their operating cycle rather
than at the end of the calendar
yearfor example, retailers at
the end of January and
agricultural firms at the end of
September.
Financial Statements and Analysis
43
Many large firms, however, operate on a 12-month financial cycle, or fiscal year,
that ends at a time other than December 31. In addition, monthly income statements are typically prepared for use by management, and quarterly statements
must be made available to the stockholders of publicly owned corporations.
Table 2.1 presents Bartlett Companys income statements for the years ended
December 31, 2003 and 2002. The 2003 statement begins with sales revenue
the total dollar amount of sales during the periodfrom which the cost of goods
sold is deducted. The resulting gross profits of $986,000 represent the amount
remaining to satisfy operating, financial, and tax costs. Next, operating expenses,
which include selling expense, general and administrative expense, lease expense,
TABLE 2.1
Bartlett Company Income
Statements ($000)
For the years ended
December 31
2003
$3,074
Sales revenue
Less: Cost of goods sold
2002
$2,567
1,711
$ 986
$ 856
$ 100
Gross profits
2,088
$ 108
194
187
Less: Operating expenses
Selling expense
General and administrative expenses
Lease expensea
35
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate
29%)b
Net profits after taxes
Less: Preferred stock dividends
35
239
223
$ 568
$ 553
$ 418
Depreciation expense
$ 303
93
91
$ 325
$ 212
94
64
$ 231
$ 148
10
10
Earnings available for common stockholders
$ 221
$ 138
Earnings per share (EPS)c
$ 2.90
$ 1.81
Dividend per share (DPS)d
$ 1.29
$ 0.75
aLease
expense is shown here as a separate item rather than being included as
part of interest expense, as specified by the FASB for financial-reporting purposes. The approach used here is consistent with tax-reporting rather than
financial-reporting procedures.
bThe 29% tax rate for 2003 results because the firm has certain special tax
write-offs that do not show up directly on its income statement.
cCalculated by dividing the earnings available for common stockholders by
the number of shares of common stock outstanding76,262 in 2003 and
76,244 in 2002. Earnings per share in 2003: $221,000 76,262 $2.90; in
2002: $138,000 76,244 $1.81.
dCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common stock outstanding. Dividends per
share in 2003: $98,000 76,262 $1.29; in 2002: $57,183 76,244 $0.75.
44
PART 1
Introduction to Managerial Finance
dividend per share (DPS)
The dollar amount of cash
distributed during the period on
behalf of each outstanding share
of common stock.
and depreciation expense, are deducted from gross profits.3 The resulting operating profits of $418,000 represent the profits earned from producing and selling
products; this amount does not consider financial and tax costs. (Operating
profit is often called earnings before interest and taxes, or EBIT.) Next, the financial costinterest expenseis subtracted from operating profits to find net profits (or earnings) before taxes. After subtracting $93,000 in 2003 interest, Bartlett
Company had $325,000 of net profits before taxes.
Next, taxes are calculated at the appropriate tax rates and deducted to determine net profits (or earnings) after taxes. Bartlett Companys net profits after
taxes for 2003 were $231,000. Any preferred stock dividends must be subtracted
from net profits after taxes to arrive at earnings available for common stockholders. This is the amount earned by the firm on behalf of the common stockholders
during the period.
Dividing earnings available for common stockholders by the number of
shares of common stock outstanding results in earnings per share (EPS). EPS represents the number of dollars earned during the period on behalf of each outstanding share of common stock. In 2003, Bartlett Company earned $221,000
for its common stockholders, which represents $2.90 for each outstanding share.
The actual cash dividend per share (DPS), which is the dollar amount of cash distributed during the period on behalf of each outstanding share of common stock,
paid in 2003 was $1.29.
Balance Sheet
balance sheet
Summary statement of the firms
financial position at a given point
in time.
current assets
Short-term assets, expected to
be converted into cash within 1
year or less.
current liabilities
Short-term liabilities, expected
to be paid within 1 year or less.
The balance sheet presents a summary statement of the firms financial position
at a given point in time. The statement balances the firms assets (what it owns)
against its financing, which can be either debt (what it owes) or equity (what was
provided by owners). Bartlett Companys balance sheets as of December 31 of
2003 and 2002 are presented in Table 2.2. They show a variety of asset, liability
(debt), and equity accounts.
An important distinction is made between short-term and long-term assets
and liabilities. The current assets and current liabilities are short-term assets and
liabilities. This means that they are expected to be converted into cash (current
assets) or paid (current liabilities) within 1 year or less. All other assets and liabilities, along with stockholders equity, which is assumed to have an infinite life,
are considered long-term, or fixed, because they are expected to remain on the
firms books for more than 1 year.
As is customary, the assets are listed from the most liquidcashdown to
the least liquid. Marketable securities are very liquid short-term investments, such
as U.S. Treasury bills or certificates of deposit, held by the firm. Because they are
highly liquid, marketable securities are viewed as a form of cash (near cash).
Accounts receivable represent the total monies owed the firm by its customers on
credit sales made to them. Inventories include raw materials, work in process
(partially finished goods), and finished goods held by the firm. The entry for
gross fixed assets is the original cost of all fixed (long-term) assets owned by the
3. Depreciation expense can be, and frequently is, included in manufacturing costscost of goods soldto calculate
gross profits. Depreciation is shown as an expense in this text to isolate its impact on cash flows.
CHAPTER 2
TABLE 2.2
Financial Statements and Analysis
Bartlett Company Balance Sheets ($000)
December 31
Assets
2003
2002
$ 363
$ 288
68
51
Current assets
Cash
Marketable securities
Accounts receivable
503
365
Inventories
289
300
$1,223
$1,004
$2,072
$1,903
Total current assets
Gross fixed assets (at
cost)a
Land and buildings
Machinery and equipment
1,866
1,693
Furniture and fixtures
358
316
Vehicles
275
314
Other (includes financial leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
98
96
$4,669
$4,322
2,295
2,056
Net fixed assets
$2,374
$2,266
Total assets
$3,597
$3,270
$ 382
$ 270
79
99
Liabilities and Stockholders Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases)b
Total liabilities
159
114
$ 620
$ 483
$1,023
$ 967
$1,643
$1,450
$ 200
$ 200
Stockholders equity
Preferred stockcumulative 5%, $100 par, 2,000 shares
authorized and issuedc
Common stock$2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2003: 76,262; in 2002: 76,244
191
190
Paid-in capital in excess of par on common stock
428
418
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity
aIn
1,135
1,012
$1,954
$1,820
$3,597
$3,270
2003, the firm has a 6-year financial lease requiring annual beginning-of-year payments of $35,000.
Four years of the lease have yet to run.
bAnnual principal repayments on a portion of the firms total outstanding debt amount to $71,000.
cThe annual preferred stock dividend would be $5 per share (5% $100 par), or a total of $10,000
annually ($5 per share 2,000 shares).
45
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PART 1
Introduction to Managerial Finance
FOCUS ON PRACTICE
Extraordinary? Not to the FASB!
To most of us, the events of September 11, 2001, would certainly
qualify as extraordinary. The plane
crashes that took thousands of
lives, destroyed the World Trade
Center Towers, and damaged part
of the Pentagon were circumstances well outside what we
consider ordinary. Yet, several
weeks after the tragedy the
Financial Accounting Standards
Board (FASB) announced that the
terrorist attack did not constitute
an extraordinary eventat least
not in accounting terms.
As a result, companies will
not be able to separate costs and
expenses related to the disaster as
extraordinary on their financial
statements. Those expenses will
show up as normal operating costs
in the continuing operations section of the income statement.
Hint Another interpretation
of the balance sheet is that on
one side are the assets that have
been purchased to be used to
increase the profit of the firm.
The other side indicates how
these assets were acquired,
either by borrowing or by
investing the owners money.
long-term debt
Debts for which payment is not
due in the current year.
paid-in capital in excess of par
The amount of proceeds in
excess of the par value received
from the original sale of common
stock.
Explained Tim Lucas, chair of the
FASB Emerging Issues Task Force,
The task force understood that
this was an extraordinary event in
the English-language sense of the
word. But in the final analysis, we
decided it wasnt going to improve
the financial reporting system to
show it [separately].
The FASB task force had prepared a draft document with
guidelines on accounting for disaster-related costs as extraordinary. As they considered how to
apply these recommendations,
they realized that the impact of the
attack was so far-ranging that it
was almost impossible to divide direct financial and economic effects from the weakening economic conditions prior to
September 11. Nor was it possible
to develop one set of guidelines
In Practice
appropriate for all industries. FASB
members were concerned that
companies would blame negative
financial performance on the attacks when in fact the costs were
unrelated. As one member pointed
out, almost every company was affected in some way. Because the
whole business climate changed,
it almost made it ordinary.
Companies will, however, be
able to separate costs they believe
to be attributable to September 11
in the footnotes to financial statements and in managements discussion of financial results.
Sources: Jennifer Davies, Will Attacks
Cover Up Weak Earnings? San Diego
Union-Tribune (October 14, 2001), pp. H1, H6;
Steve Liesman, Accountants, in a Reversal,
Say Costs from the Attack Arent Extraordinary, Wall Street Journal (October 1, 2001),
pp. C1-2; Keith Naughton, Out of the Ordinary, Newsweek (October 15, 2001), p. 9.
firm.4 Net fixed assets represent the difference between gross fixed assets and
accumulated depreciationthe total expense recorded for the depreciation of
fixed assets. (The net value of fixed assets is called their book value.)
Like assets, the liabilities and equity accounts are listed from short-term to
long-term. Current liabilities include accounts payable, amounts owed for credit
purchases by the firm; notes payable, outstanding short-term loans, typically
from commercial banks; and accruals, amounts owed for services for which a bill
may not or will not be received. (Examples of accruals include taxes due the government and wages due employees.) Long-term debt represents debt for which
payment is not due in the current year. Stockholders equity represents the owners claims on the firm. The preferred stock entry shows the historical proceeds
from the sale of preferred stock ($200,000 for Bartlett Company).
Next, the amount paid by the original purchasers of common stock is shown
by two entries: common stock and paid-in capital in excess of par on common
stock. The common stock entry is the par value of common stock. Paid-in capital
in excess of par represents the amount of proceeds in excess of the par value
received from the original sale of common stock. The sum of the common stock
4. For convenience the term fixed assets is used throughout this text to refer to what, in a strict accounting sense, is
captioned property, plant, and equipment. This simplification of terminology permits certain financial concepts
to be more easily developed.
CHAPTER 2
retained earnings
The cumulative total of all
earnings, net of dividends, that
have been retained and
reinvested in the firm since its
inception.
Financial Statements and Analysis
47
and paid-in capital accounts divided by the number of shares outstanding represents the original price per share received by the firm on a single issue of common
stock. Bartlett Company therefore received about $8.12 per share [($191,000
par $428,000 paid-in capital in excess of par) 76,262 shares] from the sale of
its common stock.
Finally, retained earnings represent the cumulative total of all earnings, net of
dividends, that have been retained and reinvested in the firm since its inception. It
is important to recognize that retained earnings are not cash but rather have been
utilized to finance the firms assets.
Bartlett Companys balance sheets in Table 2.2 show that the firms total
assets increased from $3,270,000 in 2002 to $3,597,000 in 2003. The $327,000
increase was due primarily to the $219,000 increase in current assets. The asset
increase in turn appears to have been financed primarily by an increase of
$193,000 in total liabilities. Better insight into these changes can be derived from
the statement of cash flows, which we will discuss shortly.
Statement of Retained Earnings
statement of retained earnings
Reconciles the net income
earned during a given year, and
any cash dividends paid, with the
change in retained earnings
between the start and the end of
that year.
The statement of retained earnings reconciles the net income earned during a
given year, and any cash dividends paid, with the change in retained earnings
between the start and the end of that year. Table 2.3 presents this statement for
Bartlett Company for the year ended December 31, 2003. The statement shows
that the company began the year with $1,012,000 in retained earnings and had
net profits after taxes of $231,000, from which it paid a total of $108,000 in dividends, resulting in year-end retained earnings of $1,135,000. Thus the net
increase for Bartlett Company was $123,000 ($231,000 net profits after taxes
minus $108,000 in dividends) during 2003.
Statement of Cash Flows
statement of cash flows
Provides a summary of the firms
operating, investment, and
financing cash flows and
reconciles them with changes in
its cash and marketable securities during the period.
The statement of cash flows is a summary of the cash flows over the period of
concern. The statement provides insight into the firms operating, investment,
and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Bartlett Companys statement of cash flows
for the year ended December 31, 2003, is presented in Table 2.4. Further insight
into this statement is included in the discussion of cash flow of in Chapter 3.
TABLE 2.3
Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended
December 31, 2003
Retained earnings balance (January 1, 2003)
$1,012
Plus: Net profits after taxes (for 2003)
231
Less: Cash dividends (paid during 2003)
Preferred stock
($10)
Common stock
( 98)
Total dividends paid
Retained earnings balance (December 31, 2003)
(
108)
$1,135
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PART 1
Introduction to Managerial Finance
TABLE 2.4
Bartlett Company Statement of Cash
Flows ($000) for the Year Ended
December 31, 2003
Cash Flow from Operating Activities
Net profits after taxes
$231
Depreciation
239
Increase in accounts receivable
Decrease in inventories
( 138)a
11
Increase in accounts payable
112
45
Increase in accruals
Cash provided by operating activities
$500
Cash Flow from Investment Activities
Increase in gross fixed assets
Change in business interests
($347)
0
Cash provided by investment activities
( 347)
Cash Flow from Financing Activities
Decrease in notes payable
Increase in long-term debts
Changes in stockholders
equityb
Dividends paid
($ 20)
56
11
( 108)
Cash provided by financing activities
( 61)
Net increase in cash and marketable securities
$ 92
aAs
is customary, parentheses are used to denote a negative number, which in this case is a
cash outflow.
bRetained earnings are excluded here, because their change is actually reflected in the
combination of the net profits after taxes and dividends paid entries.
Notes to the Financial Statements
notes to the financial statements
Footnotes detailing information
on the accounting policies,
procedures, calculations, and
transactions underlying entries
in the financial statements.
Included with published financial statements are explanatory notes keyed to the
relevant accounts in the statements. These notes to the financial statements provide detailed information on the accounting policies, procedures, calculations,
and transactions underlying entries in the financial statements. Common issues
addressed by these notes include revenue recognition, income taxes, breakdowns
of fixed asset accounts, debt and lease terms, and contingencies. Professional
securities analysts use the data in the statements and notes to develop estimates of
the value of securities that the firm issues, and these estimates influence the
actions of investors and therefore the firms share value.
Consolidating International Financial Statements
So far, weve discussed financial statements involving only one currency, the U.S.
dollar. The issue of how to consolidate a companys foreign and domestic financial statements has bedeviled the accounting profession for many years. The cur-
CHAPTER 2
Financial Accounting Standards
Board (FASB) Standard No. 52
Mandates that U.S.-based
companies translate their
foreign-currency-denominated
assets and liabilities into dollars,
for consolidation with the parent
companys financial statements.
This is done by using the current
rate (translation) method.
WW
W
current rate (translation) method
Technique used by U.S.-based
companies to translate their
foreign-currency-denominated
assets and liabilities into dollars,
for consolidation with the parent
companys financial statements,
using the exchange rate prevailing at the fiscal year ending date
(the current rate).
LG2
Financial Statements and Analysis
49
rent policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which mandates that U.S.-based companies translate their foreigncurrency-denominated assets and liabilities into dollars, for consolidation with
the parent companys financial statements. This is done by using a technique
called the current rate (translation) method, under which all of a U.S. parent
companys foreign-currency-denominated assets and liabilities are converted into
dollar values using the exchange rate prevailing at the fiscal year ending date (the
current rate). Income statement items are treated similarly. Equity accounts, on
the other hand, are translated into dollars by using the exchange rate that prevailed when the parents equity investment was made (the historical rate).
Retained earnings are adjusted to reflect each years operating profits or losses.
Further details on this procedure can be found at the books Web site at
www.aw.com/gitman or in an intermediate accounting text.
Review Questions
21
22
23
Describe the purpose of each of the four major financial statements.
Why are the notes to the financial statements important to professional
securities analysts?
How is the current rate (translation) method used to consolidate a firms
foreign and domestic financial statements?
2.2 Using Financial Ratios
ratio analysis
Involves methods of calculating
and interpreting financial ratios
to analyze and monitor the firms
performance.
The information contained in the four basic financial statements is of major significance to various interested parties who regularly need to have relative measures of the companys operating efficiency. Relative is the key word here,
because the analysis of financial statements is based on the use of ratios or relative values. Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firms performance. The basic inputs to
ratio analysis are the firms income statement and balance sheet.
Interested Parties
Hint Management should
be the most interested party of
this group. Managers not only
have to worry abut the
financial situation of the firm,
but they are also critically
interested in what the other
parties think about the firm.
Ratio analysis of a firms financial statements is of interest to shareholders, creditors, and the firms own management. Both present and prospective shareholders
are interested in the firms current and future level of risk and return, which
directly affect share price. The firms creditors are interested primarily in the
short-term liquidity of the company and its ability to make interest and principal
payments. A secondary concern of creditors is the firms profitability; they want
assurance that the business is healthy. Management, like stockholders, is concerned with all aspects of the firms financial situation, and it attempts to produce
financial ratios that will be considered favorable by both owners and creditors. In
addition, management uses ratios to monitor the firms performance from period
to period.
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PART 1
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Types of Ratio Comparisons
Ratio analysis is not merely the calculation of a given ratio. More important is
the interpretation of the ratio value. A meaningful basis for comparison is needed
to answer such questions as Is it too high or too low? and Is it good or bad?
Two types of ratio comparisons can be made: cross-sectional and time-series.
Cross-Sectional Analysis
cross-sectional analysis
Comparison of different firms
financial ratios at the same point
in time; involves comparing the
firms ratios to those of other
firms in its industry or to industry
averages.
benchmarking
A type of cross-sectional
analysis in which the firms ratio
values are compared to those of
a key competitor or group of
competitors that it wishes to
emulate.
Hint Industry averages are
not particularly useful for
analyzing firms with
multiproduct lines. In the case
of multiproduct firms, it is
difficult to select the
appropriate benchmark
industry.
EXAMPLE
Cross-sectional analysis involves the comparison of different firms financial
ratios at the same point in time. Analysts are often interested in how well a firm
has performed in relation to other firms in its industry. Frequently, a firm will
compare its ratio values to those of a key competitor or group of competitors that
it wishes to emulate. This type of cross-sectional analysis, called benchmarking,
has become very popular.
Comparison to industry averages is also popular. These figures can be found
in the Almanac of Business and Industrial Financial Ratios, Dun & Bradstreets
Industry Norms and Key Business Ratios, Business Month, FTC Quarterly
Reports, Robert Morris Associates Statement Studies, Value Line, and industry
sources.5 A sample from one available source of industry averages is given in
Table 2.5.
Many people mistakenly believe that as long as the firm being analyzed has a
value better than the industry average, it can be viewed favorably. However,
this better than average viewpoint can be misleading. Quite often a ratio value
that is far better than the norm can indicate problems that, on more careful
analysis, may be more severe than had the ratio been worse than the industry
average. It is therefore important to investigate significant deviations to either
side of the industry standard.
In early 2004, Mary Boyle, the chief financial analyst at Caldwell Manufacturing,
a producer of heat exchangers, gathered data on the firms financial performance
during 2003, the year just ended. She calculated a variety of ratios and obtained
industry averages. She was especially interested in inventory turnover, which
reflects the speed with which the firm moves its inventory from raw materials
through production into finished goods and to the customer as a completed sale.
Generally, higher values of this ratio are preferred, because they indicate a
quicker turnover of inventory. Caldwell Manufacturings calculated inventory
turnover for 2003 and the industry average inventory turnover were as follows:
Inventory turnover, 2003
Caldwell Manufacturing
Industry average
14.8
9.7
5. Cross-sectional comparisons of firms operating in several lines of business are difficult to perform. The use of
weighted-average industry average ratios based on the firms product-line mix or, if data are available, analysis of
the firm on a product-line basis can be performed to evaluate a multiproduct firm.
CHAPTER 2
TABLE 2.5
Line of business
(number of
concerns
reporting)b
51
Financial Statements and Analysis
Industry Average Ratios (2001) for Selected Lines of Businessa
Total
liabilities
to net
worth
(%)
Current
ratio
(X)
Quick
ratio
(X)
Sales to
inventory
(X)
Collection
period
(days)
Total
assets
to sales
(%)
Return
on total
assets
(%)
Return
on net
worth
(%)
Department
6.2
1.9
6.0
2.9
34.3
19.7
stores
3.0
0.8
4.7
8.0
50.9
62.0
4.0
8.5
14.6
1.8
3.3
(167)
1.9
0.3
3.3
34.7
68.2
164.9
6.5
0.6
0.9
2.0
Electronic
3.6
1.8
19.0
34.7
36.4
computers
1.8
1.0
9.1
55.9
59.7
121.4
7.1
11.7
23.9
230.4
1.8
3.5
(91)
1.3
0.6
5.3
85.4
102.3
9.8
428.4
(0.8)
(3.1)
2.0
Grocery
2.5
0.9
31.0
1.1
stores
1.5
0.4
19.7
2.9
14.4
46.2
2.2
9.9
24.3
20.3
128.4
0.8
3.9
(541)
1.0
0.2
14.0
11.1
5.8
31.3
294.2
0.3
1.0
3.8
Motor
2.0
1.0
vehicles
1.5
0.7
11.2
18.5
27.9
95.9
3.7
9.7
24.1
8.7
26.7
39.0
174.3
1.9
3.7
(38)
1.2
0.3
15.6
5.8
47.5
59.2
393.9
0.6
1.4
3.4
Return
on sales
(%)
aThese values are given for each ratio for each line of business. The center value is the median, and the values immediately above and below it are
the upper and lower quartiles, respectively.
bStandard Industrial Classification (SIC) codes for the lines of business shown are, respectively: SIC #5311, SIC #3571, SIC #5411, SIC #3711.
Source: Industry Norms and Key Business Ratios, Copyright 2001 Dun & Bradstreet, Inc. Reprinted with permission.
Marys initial reaction to these data was that the firm had managed its inventory significantly better than the average firm in the industry. The turnover was
nearly 53% faster than the industry average. Upon reflection, however, she realized that a very high inventory turnover could also mean very low levels of inventory. The consequence of low inventory could be excessive stockouts (insufficient
inventory). Discussions with people in the manufacturing and marketing departments did in fact uncover such a problem: Inventories during the year were
extremely low, the result of numerous production delays that hindered the firms
ability to meet demand and resulted in lost sales. What had initially appeared to
reflect extremely efficient inventory management was actually the symptom of a
major problem.
Time-Series Analysis
time-series analysis
Evaluation of the firms financial
performance over time using
financial ratio analysis.
Time-series analysis evaluates performance over time. Comparison of current to
past performance, using ratios, enables analysts to assess the firms progress.
Developing trends can be seen by using multiyear comparisons. As in crosssectional analysis, any significant year-to-year changes may be symptomatic of a
major problem.
52
PART 1
Introduction to Managerial Finance
Combined Analysis
The most informative approach to ratio analysis combines cross-sectional and
time-series analyses. A combined view makes it possible to assess the trend in the
behavior of the ratio in relation to the trend for the industry. Figure 2.1 depicts
this type of approach using the average collection period ratio of Bartlett Company, over the years 20002003. This ratio reflects the average amount of time it
takes the firm to collect bills, and lower values of this ratio generally are preferred.
The figure quickly discloses that (1) Bartletts effectiveness in collecting its receivables is poor in comparison to the industry, and (2) Bartletts trend is toward
longer collection periods. Clearly, Bartlett needs to shorten its collection period.
Cautions About Using Ratio Analysis
Before discussing specific ratios, we should consider the following cautions about
their use:
FIGURE 2.1
Combined Analysis
Combined cross-sectional
and time-series view of
Bartlett Companys average
collection period, 20002003
Average Collection Period (days)
1. Ratios with large deviations from the norm only indicate symptoms of a
problem. Additional analysis is typically needed to isolate the causes of the
problem. The fundamental point is this: Ratio analysis merely directs attention to potential areas of concern; it does not provide conclusive evidence as
to the existence of a problem.
2. A single ratio does not generally provide sufficient information from which
to judge the overall performance of the firm. Only when a group of ratios is
used can reasonable judgments be made. However, if an analysis is concerned only with certain specific aspects of a firms financial position, one or
two ratios may be sufficient.
3. The ratios being compared should be calculated using financial statements
dated at the same point in time during the year. If they are not, the effects of
70
60
Bartlett
50
Industry
40
30
2000
2001
2002
Year
2003
CHAPTER 2
Financial Statements and Analysis
53
seasonality may produce erroneous conclusions and decisions. For example,
comparison of the inventory turnover of a toy manufacturer at the end of
June with its end-of-December value can be misleading. Clearly, the seasonal
impact of the December holiday selling season would skew any comparison
of the firms inventory management.
4. It is preferable to use audited financial statements for ratio analysis. If the
statements have not been audited, the data contained in them may not reflect
the firms true financial condition.
5. The financial data being compared should have been developed in the same
way. The use of differing accounting treatmentsespecially relative to inventory and depreciationcan distort the results of ratio analysis, regardless of
whether cross-sectional or time-series analysis is used.
6. Results can be distorted by inflation, which can cause the book values of
inventory and depreciable assets to differ greatly from their true (replacement) values. Additionally, inventory costs and depreciation write-offs can
differ from their true values, thereby distorting profits. Without adjustment,
inflation tends to cause older firms (older assets) to appear more efficient and
profitable than newer firms (newer assets). Clearly, in using ratios, care must
be taken to compare older to newer firms or a firm to itself over a long period
of time.
Categories of Financial Ratios
Financial ratios can be divided for convenience into five basic categories: liquidity, activity, debt, profitability, and market ratios. Liquidity, activity, and debt
ratios primarily measure risk. Profitability ratios measure return. Market ratios
capture both risk and return.
As a rule, the inputs necessary to an effective financial analysis include, at a
minimum, the income statement and the balance sheet. We will use the 2003 and
2002 income statements and balance sheets for Bartlett Company, presented earlier in Tables 2.1 and 2.2, to demonstrate ratio calculations. Note, however, that
the ratios presented in the remainder of this chapter can be applied to almost any
company. Of course, many companies in different industries use ratios that focus
on aspects peculiar to their industry.
Review Questions
24
25
26
27
With regard to financial ratio analysis, how do the viewpoints held by the
firms present and prospective shareholders, creditors, and management
differ?
What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking?
What types of deviations from the norm should the analyst pay primary
attention to when performing cross-sectional ratio analysis? Why?
Why is it preferable to compare ratios calculated using financial statements that are dated at the same point in time during the year?
54
PART 1
Introduction to Managerial Finance
LG3
2.3 Liquidity Ratios
liquidity
A firms ability to satisfy its
short-term obligations as they
come due.
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. Liquidity refers to the solvency of the firms overall financial positionthe ease with which it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios
are viewed as good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
Current Ratio
current ratio
A measure of liquidity calculated
by dividing the firms current
assets by its current liabilities.
The current ratio, one of the most commonly cited financial ratios, measures the
firms ability to meet its short-term obligations. It is expressed as follows:
Current ratio
Current assets
Current liabilities
The current ratio for Bartlett Company in 2003 is
$1,223,000
$620,000
1.97
Generally, the higher the current ratio, the more liquid the firm is considered
to be. A current ratio of 2.0 is occasionally cited as acceptable, but a values
acceptability depends on the industry in which the firm operates. For example, a
current ratio of 1.0 would be considered acceptable for a public utility but might
be unacceptable for a manufacturing firm. The more predictable a firms cash
flows, the lower the acceptable current ratio. Because Bartlett Company is in a
business with a relatively predictable annual cash flow, its current ratio of 1.97
should be quite acceptable.
Quick (Acid-Test) Ratio
quick (acid-test) ratio
A measure of liquidity calculated
by dividing the firms current
assets minus inventory by its
current liabilities.
The quick (acid-test) ratio is similar to the current ratio except that it excludes
inventory, which is generally the least liquid current asset. The generally low liquidity of inventory results from two primary factors: (1) many types of inventory
cannot be easily sold because they are partially completed items, special-purpose
items, and the like; and (2) inventory is typically sold on credit, which means that
it becomes an account receivable before being converted into cash. The quick
ratio is calculated as follows:6
Quick ratio
Current assets Inventory
Current liabilities
The quick ratio for Bartlett Company in 2003 is
$1,223,000 $289,000
$620,000
$934,000
$620,000
1.51
6. Sometimes the quick ratio is defined as (cash marketable securities accounts receivable) current liabilities. If
a firm were to show as current assets items other than cash, marketable securities, accounts receivable, and inventories, its quick ratio might vary, depending on the method of calculation.
CHAPTER 2
Financial Statements and Analysis
55
A quick ratio of 1.0 or greater is occasionally recommended, but as with the
current ratio, what value is acceptable depends largely on the industry. The quick
ratio provides a better measure of overall liquidity only when a firms inventory
cannot be easily converted into cash. If inventory is liquid, the current ratio is a
preferred measure of overall liquidity.
Review Question
28
LG3
Under what circumstances would the current ratio be the preferred measure of overall firm liquidity? Under what circumstances would the quick
ratio be preferred?
2.4 Activity Ratios
activity ratios
Measure the speed with which
various accounts are converted
into sales or cashinflows or
outflows.
Activity ratios measure the speed with which various accounts are converted into
sales or cashinflows or outflows. With regard to current accounts, measures of
liquidity are generally inadequate because differences in the composition of a
firms current assets and current liabilities can significantly affect its true liquidity. It is therefore important to look beyond measures of overall liquidity and
to assess the activity (liquidity) of specific current accounts. A number of ratios
are available for measuring the activity of the most important current accounts,
which include inventory, accounts receivable, and accounts payable.7 The efficiency with which total assets are used can also be assessed.
Inventory Turnover
inventory turnover
Measures the activity, or liquidity, of a firms inventory.
Inventory turnover commonly measures the activity, or liquidity, of a firms
inventory. It is calculated as follows:
Inventory turnover
Cost of goods sold
Inventory
Applying this relationship to Bartlett Company in 2003 yields
Inventory turnover
$2,088,000
$289,000
7.2
The resulting turnover is meaningful only when it is compared with that of other
firms in the same industry or to the firms past inventory turnover. An inventory
7. For convenience, the activity ratios involving these current accounts assume that their end-of-period values are
good approximations of the average account balance during the periodtypically 1 year. Technically, when the
month-end balances of inventory, accounts receivable, or accounts payable vary during the year, the average balance, calculated by summing the 12 month-end account balances and dividing the total by 12, should be used
instead of the year-end value. If month-end balances are unavailable, the average can be approximated by dividing
the sum of the beginning-of-year and end-of-year balances by 2. These approaches ensure a ratio that on the average
better reflects the firms circumstances. Because the data needed to find averages are generally unavailable to the
external analyst, year-end values are frequently used to calculate activity ratios for current accounts.
56
PART 1
Introduction to Managerial Finance
average age of inventory
Average number of days sales
in inventory.
turnover of 20.0 would not be unusual for a grocery store, whereas a common
inventory turnover for an aircraft manufacturer is 4.0.
Inventory turnover can be easily converted into an average age of inventory
by dividing it into 360the assumed number of days in a year.8 For Bartlett
Company, the average age of inventory in 2003 is 50.0 days (360 7.2). This
value can also be viewed as the average number of days sales in inventory.
Average Collection Period
average collection period
The average amount of time
needed to collect accounts
receivable.
The average collection period, or average age of accounts receivable, is useful in
evaluating credit and collection policies.9 It is arrived at by dividing the average
daily sales10 into the accounts receivable balance:
Average collection period
Accounts receivable
Average sales per day
Accounts receivable
Annual sales
360
The average collection period for Bartlett Company in 2003 is
$503,000
$3,074,000
360
$503,000
$8,539
58.9 days
On the average, it takes the firm 58.9 days to collect an account receivable.
The average collection period is meaningful only in relation to the firms
credit terms. If Bartlett Company extends 30-day credit terms to customers, an
average collection period of 58.9 days may indicate a poorly managed credit or
collection department, or both. It is also possible that the lengthened collection
period resulted from an intentional relaxation of credit-term enforcement in
response to competitive pressures. If the firm had extended 60-day credit terms,
the 58.9-day average collection period would be quite acceptable. Clearly, additional information is needed to evaluate the effectiveness of the firms credit and
collection policies.
Average Payment Period
average payment period
The average amount of time
needed to pay accounts payable.
The average payment period, or average age of accounts payable, is calculated in
the same manner as the average collection period:
Average payment period
Accounts payable
Average purchases per day
8. Unless otherwise specified, a 360-day year consisting of twelve 30-day months is assumed throughout this textbook. This assumption simplifies the calculations used to illustrate key concepts.
9. The average collection period is sometimes called the days sales outstanding (DSO). A discussion of the evaluation and establishment of credit and collection policies is presented in Chapter 14.
10. The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If this is not the case,
average credit sales per day should be substituted for average sales per day.
CHAPTER 2
Financial Statements and Analysis
57
Accounts payable
Annual purchases
360
The difficulty in calculating this ratio stems from the need to find annual purchases,11 a value not available in published financial statements. Ordinarily, purchases are estimated as a given percentage of cost of goods sold. If we assume
that Bartlett Companys purchases equaled 70 percent of its cost of goods sold in
2003, its average payment period is
$382,000
0.70 $2,088,000
360
$382,000
$4,060
94.1 days
This figure is meaningful only in relation to the average credit terms extended to
the firm. If Bartlett Companys suppliers have extended, on average, 30-day
credit terms, an analyst would give Bartlett a low credit rating. Prospective
lenders and suppliers of trade credit are most interested in the average payment
period because it provides insight into the firms bill-paying patterns.
Total Asset Turnover
total asset turnover
Indicates the efficiency with
which the firm uses its assets to
generate sales.
The total asset turnover indicates the efficiency with which the firm uses its assets
to generate sales. Total asset turnover is calculated as follows:
Total asset turnover
Sales
Total assets
The value of Bartlett Companys total asset turnover in 2003 is
$3,074,000
$3,597,000
Hint
The higher the cost of
the new assets, the larger the
denominator and thus the
smaller the ratio. Therefore,
because of inflation and the use
of historical costs, firms with
newer assets will tend to have
lower turnovers than those with
older assets.
0.85
This means the company turns over its assets 0.85 times a year.
Generally, the higher a firms total asset turnover, the more efficiently its
assets have been used. This measure is probably of greatest interest to management, because it indicates whether the firms operations have been financially
efficient.
Review Question
29
To assess the firms average collection period and average payment period
ratios, what additional information is needed, and why?
11. Technically, annual credit purchasesrather than annual purchasesshould be used in calculating this ratio.
For simplicity, this refinement is ignored here.
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LG4
2.5 Debt Ratios
financial leverage
The magnification of risk and
return introduced through the use
of fixed-cost financing, such as
debt and preferred stock.
EXAMPLE
degree of indebtedness
Measures the amount of debt
relative to other significant
balance sheet amounts.
ability to service debts
The ability of a firm to make
the payments required on a
scheduled basis over the life
of a debt.
coverage ratios
Ratios that measure the firms
ability to pay certain fixed
charges.
The debt position of a firm indicates the amount of other peoples money being
used to generate profits. In general, the financial analyst is most concerned with
long-term debts, because these commit the firm to a stream of payments over the
long run. Because creditors claims must be satisfied before the earnings can be distributed to shareholders, present and prospective shareholders pay close attention
to the firms ability to repay debts. Lenders are also concerned about the firms
indebtedness. Management obviously must be concerned with indebtedness.
In general, the more debt a firm uses in relation to its total assets, the greater
its financial leverage. Financial leverage is the magnification of risk and return
introduced through the use of fixed-cost financing, such as debt and preferred
stock. The more fixed-cost debt a firm uses, the greater will be its expected risk
and return.
Patty Akers is in the process of incorporating her new business. After much
analysis she determined that an initial investment of $50,000$20,000 in current assets and $30,000 in fixed assetsis necessary. These funds can be
obtained in either of two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other alternative, the debt
plan, involves investing $25,000 and borrowing the balance of $25,000 at 12%
annual interest.
Regardless of which alternative she chooses, Patty expects sales to average
$30,000, costs and operating expenses to average $18,000, and earnings to be
taxed at a 40% rate. Projected balance sheets and income statements associated
with the two plans are summarized in Table 2.6. The no-debt plan results in
after-tax profits of $7,200, which represent a 14.4% rate of return on Pattys
$50,000 investment. The debt plan results in $5,400 of after-tax profits, which
represent a 21.6% rate of return on Pattys investment of $25,000. The debt plan
provides Patty with a higher rate of return, but the risk of this plan is also greater,
because the annual $3,000 of interest must be paid before receipt of earnings.
The example demonstrates that with increased debt comes greater risk as
well as higher potential return. Therefore, the greater the financial leverage, the
greater the potential risk and return. A detailed discussion of the impact of debt
on the firms risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial debt ratios to assess externally a firms debt position.
There are two general types of debt measures: measures of the degree of
indebtedness and measures of the ability to service debts. The degree of indebtedness measures the amount of debt relative to other significant balance sheet
amounts. A popular measure of the degree of indebtedness is the debt ratio.
The second type of debt measure, the ability to service debts, reflects a firms
ability to make the payments required on a scheduled basis over the life of a
debt.12 The firms ability to pay certain fixed charges is measured using coverage
ratios. Typically, higher coverage ratios are preferred, but too high a ratio (above
12. The term service refers to the payment of interest and repayment of principal associated with a firms debt obligations. When a firm services its debts, it paysor fulfillsthese obligations.
CHAPTER 2
TABLE 2.6
Financial Statements and Analysis
59
Financial Statements Associated with
Pattys Alternatives
No-debt plan
Debt plan
$20,000
$20,000
Balance Sheets
Current assets
Fixed assets
30,000
(1) Equity
$50,000
$
Debt (12% interest)
30,000
$50,000
Total assets
$25,000
0
50,000
25,000
$50,000
$50,000
$30,000
Total liabilities and equity
$30,000
Income Statements
Sales
Less: Costs and operating
expenses
Less: Interest expense
18,000
18,000
$12,000
Operating profits
$12,000
0
Net profit before taxes
0.12
$25,000 =
$12,000
3,000
$ 9,000
Less: Taxes (rate = 40%)
4,800
3,600
(2) Net profit after taxes
$ 7,200
$ 5,400
Return on equity [(2)
$7,200
$50,000
(1)]
14.4%
$5,400
$25,000
21.6%
industry norms) may result in unnecessarily low risk and return. In general, the
lower the firms coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances would force a firm into bankruptcy.
Two popular coverage ratios are the times interest earned ratio and the fixedpayment coverage ratio.13
Debt Ratio
debt ratio
Measures the proportion of total
assets financed by the firms
creditors.
The debt ratio measures the proportion of total assets financed by the firms creditors. The higher this ratio, the greater the amount of other peoples money being
used to generate profits. The ratio is calculated as follows:
Debt ratio
Total liabilities
Total assets
13. Coverage ratios use data that are derived on an accrual basis (discussed in Chapter 1) to measure what in a strict
sense should be measured on a cash basis. This occurs because debts are serviced by using cash flows, not the
accounting values shown on the firms financial statements. But because it is difficult to determine cash flows available for debt service from the firms financial statements, the calculation of coverage ratios as presented here is quite
common thanks to the ready availability of financial statement data.
60
PART 1
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The debt ratio for Bartlett Company in 2003 is
$1,643,000
$3,597,000
0.457
45.7%
This value indicates that the company has financed close to half of its assets with
debt. The higher this ratio, the greater the firms degree of indebtedness and the
more financial leverage it has.
Times Interest Earned Ratio
times interest earned ratio
Measures the firms ability to
make contractual interest
payments; sometimes called the
interest coverage ratio.
The times interest earned ratio, sometimes called the interest coverage ratio, measures the firms ability to make contractual interest payments. The higher its
value, the better able the firm is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:
Times interest earned ratio
Earnings before interest and taxes
Interest
The figure for earnings before interest and taxes is the same as that for operating
profits shown in the income statement. Applying this ratio to Bartlett Company
yields the following 2003 value:
Times interest earned ratio
$418,000
$93,000
4.5
The times interest earned ratio for Bartlett Company seems acceptable. A value
of at least 3.0and preferably closer to 5.0is often suggested. The firms
earnings before interest and taxes could shrink by as much as 78 percent
[(4.5 1.0) 4.5], and the firm would still be able to pay the $93,000 in interest
it owes. Thus it has a good margin of safety.
Fixed-Payment Coverage Ratio
fixed-payment coverage ratio
Measures the firms ability to
meet all fixed-payment
obligations.
The fixed-payment coverage ratio measures the firms ability to meet all fixedpayment obligations, such as loan interest and principal, lease payments, and preferred stock dividends.14 As is true of the times interest earned ratio, the higher
this value, the better. The formula for the fixed-payment coverage ratio is
Fixedpayment
coverage
ratio
Earnings before interest and taxes Lease payments
Interest Lease payments
{(Principal payments Preferred stock dividends) [1/(1 T )]}
where T is the corporate tax rate applicable to the firms income. The term
1/(1 T) is included to adjust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-
14. Although preferred stock dividends, which are stated at the time of issue, can be passed (not paid) at the
option of the firms directors, it is generally believed that the payment of such dividends is necessary. This text therefore treats the preferred stock dividend as a contractual obligation, to be paid as a fixed amount, as scheduled.
CHAPTER 2
Financial Statements and Analysis
61
tax values of all other terms. Applying the formula to Bartlett Companys 2003
data yields
Fixed-payment
coverage ratio
$93,000
$35,000
$453,000
$242,000
$418,000 $35,000
{($71,000 $10,000)
[1/(1
0.29)]}
1.9
Because the earnings available are nearly twice as large as its fixed-payment
obligations, the firm appears safely able to meet the latter.
Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the ratio, the greater the risk to both lenders and owners;
the greater the ratio, the lower the risk. This ratio allows interested parties to
assess the firms ability to meet additional fixed-payment obligations without
being driven into bankruptcy.
Review Questions
210 What is financial leverage?
211 What ratio measures the firms degree of indebtedness? What ratios assess
the firms ability to service debts?
LG5
2.6 Profitability Ratios
There are many measures of profitability. As a group, these measures enable the
analyst to evaluate the firms profits with respect to a given level of sales, a certain level of assets, or the owners investment. Without profits, a firm could not
attract outside capital. Owners, creditors, and management pay close attention to
boosting profits because of the great importance placed on earnings in the
marketplace.
Common-Size Income Statements
common-size income statement
An income statement in which
each item is expressed as a
percentage of sales.
A popular tool for evaluating profitability in relation to sales is the common-size
income statement.15 Each item on this statement is expressed as a percentage of
sales. Common-size income statements are especially useful in comparing performance across years. Three frequently cited ratios of profitability that can be read
directly from the common-size income statement are (1) the gross profit margin,
(2) the operating profit margin, and (3) the net profit margin.
Common-size income statements for 2003 and 2002 for Bartlett Company
are presented and evaluated in Table 2.7. These statements reveal that the firms
15. This statement is sometimes called a percent income statement. The same treatment is often applied to the firms
balance sheet to make it easier to evaluate changes in the asset and financial structures of the firm. In addition to
measuring profitability, these statements in effect can be used as an alternative or supplement to liquidity, activity,
and debt-ratio analysis.
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TABLE 2.7
Bartlett Company Common-Size Income
Statements
For the years ended
December 31
Evaluationa
2003
2002
20022003
100.0%
100.0%
same
67.9
66.7
worse
32.1%
33.3%
worse
Selling expense
3.3%
4.2%
better
General and administrative expenses
6.8
6.7
better
Lease expense
1.1
1.3
better
Depreciation expense
7.3
9.3
better
18.5%
21.5%
better
13.6%
11.8%
better
3.0
3.5
better
8.3%
better
Sales revenue
Less: Cost of goods sold
(1) Gross profit margin
Less: Operating expenses
Total operating expense
(2) Operating profit margin
Less: Interest expense
Net profits before taxes
10.6%
Less: Taxes
3.1
2.5
worseb
Net profits after taxes
7.5%
5.8%
better
Less: Preferred stock dividends
0.3
0.4
better
7.2%
5.4%
better
(3) Net profit margin
aSubjective
assessments based on data provided.
as a percent of sales increased noticeably between 2002 and 2003 because of differing costs and
expenses, whereas the average tax rates (taxes net profits before taxes) for 2002 and 2003 remained
about the same30% and 29%, respectively.
bTaxes
cost of goods sold increased from 66.7 percent of sales in 2002 to 67.9 percent in
2003, resulting in a worsening gross profit margin. However, thanks to a
decrease in total operating expenses, the firms net profit margin rose from 5.4
percent of sales in 2002 to 7.2 percent in 2003. The decrease in expenses more
than compensated for the increase in the cost of goods sold. A decrease in the
firms 2003 interest expense (3.0 percent of sales versus 3.5 percent in 2002)
added to the increase in 2003 profits.
Gross Profit Margin
gross profit margin
Measures the percentage of each
sales dollar remaining after the
firm has paid for its goods.
The gross profit margin measures the percentage of each sales dollar remaining
after the firm has paid for its goods. The higher the gross profit margin, the better
(that is, the lower the relative cost of merchandise sold). The gross profit margin
is calculated as follows:
Gross profit margin
Sales
Cost of goods sold
Sales
Gross profits
Sales
CHAPTER 2
FOCUS ON e-FINANCE
margin, when sales numbers were
down, the ShopKos gross profit
margin also suffered.
Software from Spotlight
Solutions, a Cincinnati company,
applied information technology to
ShopKos decisions about markdowns. Company research indicated that multiple markdowns are
not so profitable as properly timed
single markdowns. It developed a
program (Markdown Optimizer) to
automate optimal price change actions so that retailers can achieve
higher sales and margins from existing merchandise inventories.
The program analyzes several
years of sales figures on similar
products and develops a demand
pattern, taking into account the
sensitivity of customer demand to
price changes (price elasticity).
The software is dynamicthat is,
it learns retail customers preferences and incorporates that information into its models.
63
In Practice
ShopKos Software Solution
Specialized financial analysis help tools
can companies achieve significant improvements in ratio
measures of performance. With
assistance from sophisticated new
software programs, for example,
companies can convert masses of
historical sales data into useful
information that guides pricing
strategy and improves operating
efficiency.
Like many of its rivals,
ShopKo Stores, a Fortune 500 discount chain based in Green Bay,
Wisconsin, had no underlying
strategy to sell slow-moving
items. It used guesstimates to
reduce prices a bit at a time, until
eventually the merchandise sold.
However, total sales suffered from
the companys having no way to
determine the maximum price at
which goods would sell. Because
the dollar volume of sales enters
into both the numerator and the
denominator in the gross profit
Hint This is a very
significant ratio for small
retailers, especially during times
of inflationary prices. If the
owner of the firm does not raise
prices when the cost of sales is
rising, the gross profit margin
will erode.
Financial Statements and Analysis
During a six-month pilot project, ShopKo provided three years
of sales data on 300 apparel, home,
and other products. Markdown
Optimizer ran through a series of
mathematical models to arrive at
optimal timing for and amount of
price cuts. ShopKo tracked and
compared sales for these clearance items using the recommended markdowns. Sales on
those products were 14 percent
higher than the prior year. The
companys gross profit margin
rose 24 percent, despite flat samestore sales in one quarter. ShopKo
now uses Markdown Optimizer for
all products.
Sources: Amy Merrick, Retailers Try to Get
Leg Up on Markdowns with New Software,
Wall Street Journal (August 7, 2001), pp. A1,
A6; ShopKo Uses Spotlight Solutions
Price Optimization Software, downloaded
from Spotlight Solutions Web site, www.
spotlightsolutions.com/cshopko.html,
November 6, 2001.
Bartlett Companys gross profit margin for 2003 is
$3,074,000 $2,088,000
$3,074,000
$986,000
$3,074,000
32.1%
This value is labeled (1) on the common-size income statement in Table 2.7.
Operating Profit Margin
operating profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses other than
interest, taxes, and preferred
stock dividends are deducted;
the pure profits earned on each
sales dollar.
The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the pure profits earned on each sales dollar.
Operating profits are pure because they measure only the profits earned on
operations and ignore interest, taxes, and preferred stock dividends. A high operating profit margin is preferred. The operating profit margin is calculated as
follows:
Operating profit margin
Operating profits
Sales
64
PART 1
Introduction to Managerial Finance
Bartlett Companys operating profit margin for 2003 is
$418,000
$3,074,000
13.6%
This value is labeled (2) on the common-size income statement in Table 2.7.
Net Profit Margin
net profit margin
Measures the percentage of each
sales dollar remaining after all
costs and expenses, including
interest, taxes, and preferred
stock dividends, have been
deducted.
The net profit margin measures the percentage of each sales dollar remaining
after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firms net profit margin, the better.
The net profit margin is calculated as follows:
Net profit margin
Earnings available for common stockholders
Sales
Bartlett Companys net profit margin for 2003 is
$221,000
$3,074,000
7.2%
This value is labeled (3) on the common-size income statement in Table 2.7.
The net profit margin is a commonly cited measure of the firms success with
respect to earnings on sales. Good net profit margins differ considerably across
industries. A net profit margin of 1 percent or less would not be unusual for a
grocery store, whereas a net profit margin of 10 percent would be low for a retail
jewelry store.
Earnings per Share (EPS)
Hint EPS represents the
dollar amount earned on behalf
of each sharenot the amount
of earnings actually distributed
to shareholders.
The firms earnings per share (EPS) is generally of interest to present or prospective stockholders and management. As we noted earlier, EPS represents the number of dollars earned during the period on behalf of each outstanding share of
common stock. Earnings per share is calculated as follows:
Earnings per share
Earnings available for common stockholders
Number of shares of common stock outstanding
Bartlett Companys earnings per share in 2003 is
$221,000
76,262
$2.90
This figure represents the dollar amount earned on behalf of each share. The dollar amount of cash actually distributed to each shareholder is the dividend per
share (DPS), which, as noted in Bartlett Companys income statement (Table
2.1), rose to $1.29 in 2003 from $0.75 in 2002. EPS is closely watched by the
investing public and is considered an important indicator of corporate success.
CHAPTER 2
Financial Statements and Analysis
65
Return on Total Assets (ROA)
return on total assets (ROA)
Measures the overall effectiveness of management in generating profits with its available
assets; also called the return on
investment (ROI).
The return on total assets (ROA), often called the return on investment (ROI),
measures the overall effectiveness of management in generating profits with its
available assets. The higher the firms return on total assets, the better. The return
on total assets is calculated as follows:
Return on total assets
Earnings available for common stockholders
Total assets
Bartlett Companys return on total assets in 2003 is
$221,000
$3,597,000
6.1%
This value indicates that the firm earned 6.1 cents on each dollar of asset
investment.
Return on Common Equity (ROE)
return on common equity (ROE)
Measures the return earned on
the common stockholders
investment in the firm.
The return on common equity (ROE) measures the return earned on the common
stockholders investment in the firm. Generally, the higher this return, the better
off are the owners. Return on common equity is calculated as follows:
Return on common equity
Earnings available for common stockholders
Common stock equity
This ratio for Bartlett Company in 2003 is
$221,000
$1,754,000
12.6%
Note that the value for common stock equity ($1,754,000) was found by subtracting the $200,000 of preferred stock equity from the total stockholders
equity of $1,954,000 (see Bartlett Companys 2003 balance sheet in Table 2.2).
The calculated ROE of 12.6 percent indicates that during 2003 Bartlett earned
12.6 cents on each dollar of common stock equity.
Review Questions
212 What three ratios of profitability are found on a common-size income
statement?
213 What would explain a firms having a high gross profit margin and a low
net profit margin?
214 Which measure of profitability is probably of greatest interest to the
investing public? Why?
66
PART 1
Introduction to Managerial Finance
LG5
2.7 Market Ratios
market ratios
Relate a firms market value, as
measured by its current share
price, to certain accounting
values.
Market ratios relate the firms market value, as measured by its current share
price, to certain accounting values. These ratios give insight into how well
investors in the marketplace feel the firm is doing in terms of risk and return.
They tend to reflect, on a relative basis, the common stockholders assessment of
all aspects of the firms past and expected future performance. Here we consider
two popular market ratios, one that focuses on earnings and another that considers book value.
Price/Earnings (P/E) Ratio
price/earnings (P/E) ratio
Measures the amount that
investors are willing to pay for
each dollar of a firms earnings;
the higher the P/E ratio, the
greater is investor confidence.
The price/earnings (P/E) ratio is commonly used to assess the owners appraisal
of share value.16 The P/E ratio measures the amount that investors are willing to
pay for each dollar of a firms earnings. The level of the price/earnings ratio indicates the degree of confidence that investors have in the firms future performance. The higher the P/E ratio, the greater is investor confidence. The P/E ratio
is calculated as follows:
Price/earnings (P/E) ratio
Market price per share of common stock
Earnings per share
If Bartlett Companys common stock at the end of 2003 was selling at $32.25,
using the EPS of $2.90, the P/E ratio at year-end 2003 is
$32.25
$2.90
11.1
This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The P/E ratio is most informative when applied in cross-sectional analysis
using an industry average P/E ratio or the P/E ratio of a benchmark firm.
Market/Book (M/B) Ratio
market/book (M/B) ratio
Provides an assessment of how
investors view the firms performance. Firms expected to earn
high returns relative to their risk
typically sell at higher M/B
multiples.
The market/book (M/B) ratio provides an assessment of how investors view the
firms performance. It relates the market value of the firms shares to their
bookstrict accountingvalue. To calculate the firms M/B ratio, we first need
to find the book value per share of common stock:
Book value per
share of common stock
Common stock equity
Number of shares of common stock outstanding
Substituting the appropriate values for Bartlett Company from its 2003 balance
sheet, we get
Book value per share of common stock
$1,754,000
76,262
$23.00
16. Use of the price/earnings ratio to estimate the value of the firm is part of the discussion of Other approaches to
common stock valuation in Chapter 7.
CHAPTER 2
Financial Statements and Analysis
67
The formula for the market/book ratio is
Market/book (M/B) ratio
Market price per share of common stock
Book value per share of common stock
Substituting Bartlett Companys end of 2003 common stock price of $32.25 and
its $23.00 book value per share of common stock (calculated above) into the M/B
ratio formula, we get
Market/book (M/B) ratio
$32.25
$23.00
1.40
This M/B ratio means that investors are currently paying $1.40 for each $1.00 of
book value of Bartlett Companys stock.
The stocks of firms that are expected to perform wellimprove profits,
increase their market share, or launch successful productstypically sell at
higher M/B ratios than the stocks of firms with less attractive outlooks. Simply
stated, firms expected to earn high returns relative to their risk typically sell at
higher M/B multiples. Clearly, Bartletts future prospects are being viewed favorably by investors, who are willing to pay more than its book value for the firms
shares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally, to get a
feel for the firms risk and return compared to peer firms.
Review Question
215 How do the price/earnings (P/E) ratio and the market/book (M/B) ratio
provide a feel for the firms risk and return?
LG6
2.8 A Complete Ratio Analysis
Analysts frequently wish to take an overall look at the firms financial performance and status. Here we consider two popular approaches to a complete ratio
analysis: (1) summarizing all ratios and (2) the DuPont system of analysis. The
summary analysis approach tends to view all aspects of the firms financial activities to isolate key areas of responsibility. The DuPont system acts as a search
technique aimed at finding the key areas responsible for the firms financial
condition.
Summarizing All Ratios
We can use Bartlett Companys ratios to perform a complete ratio analysis using
both cross-sectional and time-series analysis approaches. The 2003 ratio values
calculated earlier and the ratio values calculated for 2001 and 2002 for Bartlett
Company, along with the industry average ratios for 2003, are summarized in
Table 2.8, which also shows the formula used to calculate each ratio. Using these
data, we can discuss the five key aspects of Bartletts performanceliquidity,
activity, debt, profitability, and market.
68
Earnings before interest and taxes
Interest
1.5
good
Times interest earned ratio
1.9
OK
5.1
5.7
1.32
good
2.08
2002b
OK
3.3
44.3%
0.94
81.2 days
4.5
45.7%
0.79
94.1 days
51.2 days
7.2
1.46
1.97
2003b
4.3
40.0%
0.85
66.5 days
58.9 days
6.6
1.51
2.05
Industry
average
2003c
good
OK
0.75
poor
44.3 days
good
1.43
OK
Crosssectional
2003
Earnings before interest and taxes Lease payments
Fixed-payment coverage ratio
Int. Lease pay. {(Prin. Pref. div.) [1/(1 T )]}
good
5.6
36.8%
Sales
Total assets
75.8 days
Accounts receivable
43.9 days
Average sales per day
Total asset turnover
Total liabilities
Total assets
Accounts payable
Average purchases per day
Debt ratio
Debt
Average payment period
poor
2.04
2001a
Current assets Inventory
Current liabilities
Average collection period
Quick (acid-test) ratio
Cost of goods sold
Inventory
Current assets
Current liabilities
Formula
Year
Summary of Bartlett Company Ratios (20012003, Including 2003 Industry Averages)
Inventory turnover
Activity
Current ratio
Liquidity
Ratio
TABLE 2.8
2.4
OK
OK
OK
poor
poor
good
OK
OK
Timeseries
20012003
Evaluationd
1.4
OK
OK
OK
poor
poor
good
good
OK
Overall
69
Operating profit margin
Gross profits
Sales
Formula
Earnings available for common stockholders
Total assets
OK
Return on total assets
(ROA)
Return on common equity
(ROE)
good
good
Market price per share of common stock
Earnings per share
$2.26
good
$2.90
OK
bCalculated
from data not included in the chapter.
by using the financial statements presented in Tables 2.1 and 2.2.
1.40
OK
aCalculated
1.30
OK
Price/earnings (P/E) ratio
Market
Earnings available for common stockholders
Sales
Net profit margin
5.4%
14.6%
33.3%
2002b
7.2%
11.8%
32.1%
2003b
6.2%
13.6%
30.0%
Industry
average
2003c
good
11.0%
OK
Crosssectional
2003
OK
good
OK
Timeseries
20012003
4.2%
6.1%
10.0e
11.1
12.5
13.7%
4.6%
OK
8.5%
good
Market price per share of common stock
Market/book (M/B) ratio
Book value per share of common stock
OK
10.5
Earnings available for common stockholders
Common stock equity
7.8%
1.25
OK
12.6%
OK
Earnings available for common stockholders
Earnings per share (EPS)
$3.26
Number of shares of common stock outstanding
good
8.2%
good
31.4%
2001a
Operating profits
Sales
Gross profit margin
Profitability
Ratio
Year
Evaluationd
0.85e
OK
8.5%
good
$1.81
good
OK
OK
Overall
70
PART 1
Introduction to Managerial Finance
Liquidity
The overall liquidity of the firm seems to exhibit a reasonably stable trend, having been maintained at a level that is relatively consistent with the industry average in 2003. The firms liquidity seems to be good.
Activity
Bartlett Companys inventory appears to be in good shape. Its inventory management seems to have improved, and in 2003 it performed at a level above that of
the industry. The firm may be experiencing some problems with accounts receivable. The average collection period seems to have crept up above that of the
industry. Bartlett also appears to be slow in paying its bills; it pays nearly 30 days
slower than the industry average. This could adversely affect the firms credit
standing. Although overall liquidity appears to be good, the management of
receivables and payables should be examined. Bartletts total asset turnover
reflects a decline in the efficiency of total asset utilization between 2001 and
2002. Although in 2003 it rose to a level considerably above the industry average, it appears that the pre-2002 level of efficiency has not yet been achieved.
Debt
Bartlett Companys indebtedness increased over the 20012003 period and is
currently above the industry average. Although this increase in the debt ratio
could be cause for alarm, the firms ability to meet interest and fixed-payment
obligations improved, from 2002 to 2003, to a level that outperforms the industry. The firms increased indebtedness in 2002 apparently caused a deterioration
in its ability to pay debt adequately. However, Bartlett has evidently improved its
income in 2003 so that it is able to meet its interest and fixed-payment obligations at a level consistent with the average in the industry. In summary, it appears
that although 2002 was an off year, the companys ability to pay debts in 2003
compensates for its increased degree of indebtedness.
Profitability
Bartletts profitability relative to sales in 2003 was better than the average company in the industry, although it did not match the firms 2001 performance.
Although the gross profit margin was better in 2002 and 2003 than in 2001,
higher levels of operating and interest expenses in 2002 and 2003 appear to have
caused the 2003 net profit margin to fall below that of 2001. However, Bartlett
Companys 2003 net profit margin is quite favorable when compared to the
industry average.
The firms earnings per share, return on total assets, and return on common
equity behaved much as its net profit margin did over the 20012003 period.
Bartlett appears to have experienced either a sizable drop in sales between 2001
and 2002 or a rapid expansion in assets during that period. The exceptionally
high 2003 level of return on common equity suggests that the firm is performing
quite well. The firms above-average returnsnet profit margin, EPS, ROA, and
ROEmay be attributable to the fact that it is more risky than average. A look at
market ratios is helpful in assessing risk.
CHAPTER 2
Financial Statements and Analysis
71
Market
Investors have greater confidence in the firm in 2003 than in the prior two years,
as reflected in the price/earnings (P/E) ratio of 11.1. However, this ratio is below
the industry average. The P/E ratio suggests that the firms risk has declined but
remains above that of the average firm in its industry. The firms market/book
(M/B) ratio has increased over the 20012003 period, and in 2003 it exceeds the
industry average. This implies that investors are optimistic about the firms future
performance. The P/E and M/B ratios reflect the firms increased profitability
over the 20012003 period: Investors expect to earn high future returns as compensation for the firms above-average risk.
In summary, the firm appears to be growing and has recently undergone an
expansion in assets, financed primarily through the use of debt. The 20022003
period seems to reflect a phase of adjustment and recovery from the rapid growth
in assets. Bartletts sales, profits, and other performance factors seem to be growing with the increase in the size of the operation. In addition, the market response
to these accomplishments appears to have been positive. In short, the firm seems
to have done well in 2003.
DuPont System of Analysis
DuPont system of analysis
System used to dissect the firms
financial statements and to
assess its financial condition.
DuPont formula
Multiplies the firms net profit
margin by its total asset turnover
to calculate the firms return on
total assets (ROA).
The DuPont system of analysis is used to dissect the firms financial statements
and to assess its financial condition. It merges the income statement and balance
sheet into two summary measures of profitability: return on total assets (ROA)
and return on common equity (ROE). Figure 2.2 depicts the basic DuPont system
with Bartlett Companys 2003 monetary and ratio values. The upper portion of
the chart summarizes the income statement activities; the lower portion summarizes the balance sheet activities.
The DuPont system first brings together the net profit margin, which measures
the firms profitability on sales, with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales. In the DuPont formula, the
product of these two ratios results in the return on total assets (ROA):
ROA
Net profit margin
Total asset turnover
Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
ROA
Earnings available for
common stockholders
Sales
Sales
Total assets
Earnings available for
common stockholders
Total assets
When the 2003 values of the net profit margin and total asset turnover for
Bartlett Company, calculated earlier, are substituted into the DuPont formula, the
result is
ROA
7.2%
0.85
6.1%
This value is the same as that calculated directly in an earlier section (page 65).
The DuPont formula enables the firm to break down its return into profit-onsales and efficiency-of-asset-use components. Typically, a firm with a low net
profit margin has a high total asset turnover, which results in a reasonably good
return on total assets. Often, the opposite situation exists.
PART 1
Introduction to Managerial Finance
FIGURE 2.2
DuPont System of Analysis
The DuPont system of analysis with application to Bartlett Company (2003)
Sales
$3,074,000
minus
Income
Statement
Cost of
Goods Sold
$2,088,000
minus
Operating
Expenses
$568,000
minus
Earnings
Available
for Common
Stockholders
$221,000
divided by
Net Profit
Margin
7.2%
Sales
$3,074,000
Interest
Expense
$93,000
minus
Taxes
$94,000
multiplied
by
minus
Return on
Total Assets
(ROA)
6.1%
Preferred Stock
Dividends
$10,000
Sales
$3,074,000
Current
Assets
$1,223,000
divided by
plus
Balance
Sheet
72
Total Asset
Turnover
0.85
Total Assets
$3,597,000
multiplied
by
Net Fixed
Assets
$2,374,000
Current
Liabilities
$620,000
plus
Long-Term
Debt
$1,023,000
Total
Liabilities
$1,643,000
plus
Stockholders
Equity
$1,954,000
Total Liabilities
and Stockholders
Equity = Total
Assets
$3,597,000
divided by
Common Stock
Equity
$1,754,000
Financial
Leverage
Multiplier (FLM)
2.06
Return on
Common
Equity (ROE)
12.6%
CHAPTER 2
modified DuPont formula
Relates the firms return on total
assets (ROA) to its return on
common equity (ROE) using the
financial leverage multiplier
(FLM).
financial leverage multiplier
(FLM)
The ratio of the firms total assets
to its common stock equity.
Financial Statements and Analysis
73
The second step in the DuPont system employs the modified DuPont formula.
This formula relates the firms return on total assets (ROA) to its return on common equity (ROE). The latter is calculated by multiplying the return on total
assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
ROE
ROA
FLM
Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
ROE
Earnings available for
common stockholders
Total assets
Total assets
Common stock
equity
Earnings available for
common stockholders
Common stock
equity
Use of the financial leverage multiplier (FLM) to convert the ROA into the
ROE reflects the impact of financial leverage on owners return. Substituting the
values for Bartlett Companys ROA of 6.1 percent, calculated earlier, and
Bartletts FLM of 2.06 ($3,597,000 total assets $1,754,000 common stock
equity) into the modified DuPont formula yields
ROE
6.1%
2.06
12.6%
The 12.6 percent ROE calculated by using the modified DuPont formula is the
same as that calculated directly (page 65).
The advantage of the DuPont system is that it allows the firm to break its return
on equity into a profit-on-sales component (net profit margin), an efficiency-ofasset-use component (total asset turnover), and a use-of-financial-leverage component (financial leverage multiplier). The total return to owners therefore can be
analyzed in these important dimensions.
The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure 2.2. Beginning with the rightmost valuethe ROEthe
financial analyst moves to the left, dissecting and analyzing the inputs to the formula in order to isolate the probable cause of the resulting above-average (or
below-average) value. For the sake of discussion, lets assume that Bartletts ROE
of 12.6 percent is actually below the industry average. Moving to the left, we
would examine the inputs to the ROEthe ROA and the FLMrelative to the
industry averages. Lets assume that the FLM is in line with the industry average,
but the ROA is below the industry average. Moving farther to the left, we examine the two inputs to the ROAthe net profit margin and total asset turnover.
Assume that the net profit margin is in line with the industry average, but the
total asset turnover is below the industry average. Moving still farther to the left,
we find that whereas the firms sales are consistent with the industry value,
Bartletts total assets have grown significantly during the past year. Looking farther to the left, we would review the firms activity ratios for current assets. Lets
say that whereas the firms inventory turnover is in line with the industry average,
its average collection period is well above the industry average.
Clearly, we can trace the possible problem back to its cause: Bartletts low
ROE is primarily the consequence of slow collections of accounts receivable,
which resulted in high levels of receivables and therefore high levels of total
assets. The high total assets slowed Bartletts total asset turnover, driving down
its ROA, which then drove down its ROE. By using the DuPont system of analysis
74
PART 1
Introduction to Managerial Finance
to dissect Bartletts overall returns as measured by its ROE, we found that slow
collections of receivables caused the below-industry-average ROE. Clearly, the
firm needs to manage its credit operations better.
Review Questions
216 Financial ratio analysis is often divided into five areas: liquidity, activity,
debt, profitability, and market ratios. Differentiate each of these areas of
analysis from the others. Which is of the greatest concern to creditors?
217 Describe how you would use a large number of ratios to perform a complete ratio analysis of the firm.
218 What three areas of analysis are combined in the modified DuPont formula? Explain how the DuPont system of analysis is used to dissect the
firms results and isolate their causes.
S U M M A RY
FOCUS ON VALUE
Financial managers review and analyze the firms financial statements periodically, both to
uncover developing problems and to assess the firms progress toward achieving its goals.
These actions are aimed at preserving and creating value for the firms owners. Financial
ratios enable financial managers to monitor the pulse of the firm and its progress toward its
strategic goals. Although financial statements and financial ratios rely on accrual concepts,
they can provide useful insights into important aspects of risk and return (cash flow) that
affect share price, which management is attempting to maximize.
REVIEW OF LEARNING GOALS
Review the contents of the stockholders report and the procedures for consolidating international financial statements. The annual stockholders report, which publicly owned corporations
are required to provide to stockholders, documents
the firms financial activities during the past year.
It includes the letter to stockholders and various
subjective and factual information, as well as four
key financial statements: the income statement, the
balance sheet, the statement of retained earnings,
and the statement of cash flows. Notes describing
the technical aspects of the financial statements follow them. Financial statements of companies that
have operations whose cash flows are denominated
in one or more foreign currencies must be transLG1
lated into dollars in accordance with FASB
Standard No. 52.
Understand who uses financial ratios, and how.
Ratio analysis enables present and prospective
stockholders and lenders and the firms management to evaluate the firms financial performance. It
can be performed on a cross-sectional or a timeseries basis. Benchmarking is a popular type of
cross-sectional analysis. Key cautions for applying
financial ratios are: (1) Ratios with large deviations
from the norm only indicate symptoms of a problem. (2) A single ratio does not generally provide
sufficient information. (3) The ratios being compared should be calculated using financial stateLG2
CHAPTER 2
ments dated at the same point in time during the
year. (4) Audited financial statements should be
used. (5) Data should be checked for consistency of
accounting treatment. (6) Inflation and different asset ages can distort ratio comparisons.
Use ratios to analyze a firms liquidity and activity. Liquidity, or ability of the firm to pay
its bills as they come due, can be measured by the
current ratio and the quick (acid-test) ratio. Activity ratios measure the speed with which accounts
are converted into sales or cashinflows or outflows. The activity of inventory can be measured
by its turnover, that of accounts receivable by the
average collection period, and that of accounts
payable by the average payment period. Total asset
turnover measures the efficiency with which the
firm uses its assets to generate sales. Formulas for
these liquidity and activity ratios are summarized
in Table 2.8.
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Discuss the relationship between debt and financial leverage and the ratios used to analyze
a firms debt. The more debt a firm uses, the greater
its financial leverage, which magnifies both risk and
return. Financial debt ratios measure both the degree of indebtedness and the ability to service debts.
A common measure of indebtedness is the debt ratio. The ability to pay fixed charges can be measured by times interest earned and fixed-payment
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SELF-TEST PROBLEMS
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Financial Statements and Analysis
75
coverage ratios. Formulas for these debt ratios are
summarized in Table 2.8.
Use ratios to analyze a firms profitability and
its market value. The common-size income
statement, which shows all items as a percentage of
sales, can be used to determine gross profit margin,
operating profit margin, and net profit margin.
Other measures of profitability include earnings per
share, return on total assets, and return on common
equity. Market ratios include the price/earnings ratio and the market/book ratio. Formulas for these
profitability and market ratios are summarized in
Table 2.8.
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Use a summary of financial ratios and the
DuPont system of analysis to perform a complete ratio analysis. A summary of all ratiosliquidity, activity, debt, profitability, and marketas
shown in Table 2.8 can be used to perform a complete ratio analysis using cross-sectional and timeseries analysis approaches. The DuPont system of
analysis, summarized in Figure 2.2, is a diagnostic
tool used to find the key areas responsible for the
firms financial performance. It enables the firm to
break the return on common equity into three components: profit on sales, efficiency of asset use, and
use of leverage. The DuPont system of analysis
makes it possible to assess all aspects of the firms activities in order to isolate key areas of responsibility.
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(Solutions in Appendix B)
Ratio formulas and interpretations Without referring to the text, indicate for
each of the following ratios the formula for calculating it and the kinds of problems, if any, the firm is likely to have if that ratio is too high relative to the
industry average. What if the ratio is too low relative to the industry? Create a
table similar to the one that follows and fill in the empty blocks.
Ratio
Current ratio
Inventory turnover
Times interest earned
Gross profit margin
Return on total assets
Too high
Too low
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Introduction to Managerial Finance
ST 22
Balance sheet completion using ratios Complete the 2003 balance sheet for
OKeefe Industries using the information that follows it.
OKeefe Industries
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders Equity
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
$30,000
25,000
$
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders equity
Total liabilities and
stockholders equity
$120,000
20,000
$600,000
$
The following financial data for 2003 are also available:
(1) Sales totaled $1,800,000.
(6) The current ratio was 1.60.
(2) The gross profit margin was 25%.
(7) The total asset turnover ratio
(3) Inventory turnover was 6.0.
was 1.20.
(4) There are 360 days in the year.
(8) The debt ratio was 60%.
(5) The average collection period
was 40 days.
PROBLEMS
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21
Reviewing basic financial statements The income statement for the year ended
December 31, 2003, the balance sheets for December 31, 2003 and 2002, and
the statement of retained earnings for the year ended December 31, 2003, for
Technica, Inc., are given here. Briefly discuss the form and informational content
of each of these statements.
Technica, Inc.
Income Statement
for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses
General and administrative expense
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes
Earnings available for common stockholders
Earnings per share (EPS)
$600,000
460,000
$140,000
$30,000
30,000
60,000
$ 80,000
10,000
$ 70,000
27,100
$ 42,900
$2.15
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Financial Statements and Analysis
77
Technica, Inc.
Balance Sheets
December 31
Assets
2003
2002
Cash
$ 15,000
$ 16,000
7,200
8,000
Marketable securities
Accounts receivable
34,100
42,200
Inventories
82,000
50,000
Total current assets
Land and buildings
$138,300
$116,200
$150,000
$150,000
200,000
190,000
Machinery and equipment
Furniture and fixtures
54,000
50,000
Other
11,000
10,000
$415,000
$400,000
Total gross fixed assets
Less: Accumulated depreciation
145,000
115,000
Net fixed assets
$270,000
$285,000
Total assets
$408,300
$401,200
$ 57,000
$ 49,000
13,000
16,000
5,000
6,000
Liabilities and Stockholders Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
$ 75,000
$ 71,000
$150,000
Long-term debt
$160,000
$110,200
$120,000
Stockholders equity
Common stock equity (shares
outstanding: 19,500 in 2003 and
20,000 in 2002)
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity
73,100
50,200
$183,300
$170,200
$408,300
$401,200
Technica, Inc.
Statement of Retained Earnings
for the Year Ended December 31, 2003
Retained earnings balance (January 1, 2003)
Plus: Net profits after taxes (for 2003)
$50,200
42,900
Less: Cash dividends (paid during 2003)
Retained earnings balance (December 31, 2003)
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( 20,000)
$73,100
Financial statement account identification Mark each of the accounts listed in
the following table as follows:
a. In column (1), indicate in which statementincome statement (IS) or balance
sheet (BS)the account belongs.
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Introduction to Managerial Finance
b. In column (2), indicate whether the account is a current asset (CA), current
liability (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue
(R), or stockholders equity (SE).
Account name
(1)
Statement
(2)
Type of account
Accounts payable
Accounts receivable
Accruals
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debts
Machinery
Marketable securities
Notes payable
Operating expense
Paid-in capital in excess of par
Preferred stock
Preferred stock dividends
Retained earnings
Sales revenue
Selling expense
Taxes
Vehicles
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Income statement preparation On December 31, 2003, Cathy Chen, a selfemployed certified public accountant (CPA), completed her first full year in business. During the year, she billed $180,000 for her accounting services. She had
two employees: a bookkeeper and a clerical assistant. In addition to her monthly
salary of $4,000, Ms. Chen paid annual salaries of $24,000 and $18,000 to the
bookkeeper and the clerical assistant, respectively. Employment taxes and benefit
costs for Ms. Chen and her employees totaled $17,300 for the year. Expenses for
office supplies, including postage, totaled $5,200 for the year. In addition, Ms.
Chen spent $8,500 during the year on tax-deductible travel and entertainment
associated with client visits and new business development. Lease payments for
CHAPTER 2
Financial Statements and Analysis
79
the office space rented (a tax-deductible expense) were $1,350 per month. Depreciation expense on the office furniture and fixtures was $7,800 for the year. During the year, Ms. Chen paid interest of $7,500 on the $60,000 borrowed to start
the business. She paid an average tax rate of 30 percent during 2003.
a. Prepare an income statement for Cathy Chen, CPA, for the year ended
December 31, 2003.
b. Evaluate her 2003 financial performance.
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Calculation of EPS and retained earnings Philagem, Inc., ended 2003 with net
profit before taxes of $218,000. The company is subject to a 40% tax rate and
must pay $32,000 in preferred stock dividends before distributing any earnings
on the 85,000 shares of common stock currently outstanding.
a. Calculate Philagems 2003 earnings per share (EPS).
b. If the firm paid common stock dividends of $0.80 per share, how many dollars would go to retained earnings?
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Balance sheet preparation Use the appropriate items from the following list to
prepare in good form Owen Davis Companys balance sheet at December 31,
2003.
Item
Accounts payable
Accounts receivable
Accruals
Value ($000) at
December 31, 2003
$ 220
450
55
Accumulated depreciation
265
Buildings
225
Cash
215
Common stock (at par)
Cost of goods sold
Depreciation expense
Equipment
90
2,500
45
140
Furniture and fixtures
170
General expense
320
Inventories
375
Land
100
Long-term debts
420
Machinery
420
Marketable securities
Notes payable
75
475
Paid-in capital in excess of par
360
Preferred stock
100
Retained earnings
Sales revenue
Vehicles
210
3,600
25
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Impact of net income on a firms balance sheet Conrad Air, Inc., reported net
income of $1,365,000 for the year ended December 31, 2003. Show the effect of
these funds on the firms balance sheet for the previous year (below) in each of
the scenarios following the balance sheet.
Conrad Air, Inc.
Balance Sheet
as of December 31, 2003
Assets
Liabilities and Stockholders Equity
Cash
$ 120,000
Marketable securities
35,000
Accounts receivable
45,000
Inventories
130,000
Current assets
Equipment
$ 330,000
$2,970,000
Buildings
1,600,000
Fixed assets
Accounts payable
$
Short-term notes
70,000
55,000
Current liabilities
$ 125,000
Long-term debt
$2,700,000
Total liabilities
$2,825,000
Common stock
$ 500,000
Retained earnings
1,575,000
Stockholders equity
$2,075,000
$4,900,000
Total assets
$4,570,000
Total liabilities and equity
$4,900,000
a. Conrad paid no dividends during the year and invested the funds in marketable securities.
b. Conrad paid dividends totaling $500,000 and used the balance of the net
income to retire (pay off) long-term debt.
c. Conrad paid dividends totaling $500,000 and invested the balance of the net
income in building a new hangar.
d. Conrad paid out all $1,365,000 as dividends to its stockholders.
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Initial sale price of common stock Beck Corporation has one issue of preferred
stock and one issue of common stock outstanding. Given Becks stockholders
equity account that follows, determine the original price per share at which the
firm sold its single issue of common stock.
Stockholders Equity ($000)
Preferred stock
Common stock ($0.75 par, 300,000 shares outstanding)
Paid-in capital in excess of par on common stock
Retained earnings
Total stockholders equity
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28
$ 125
225
2,625
900
$3,875
Statement of retained earnings Hayes Enterprises began 2003 with a retained
earnings balance of $928,000. During 2003, the firm earned $377,000 after
taxes. From this amount, preferred stockholders were paid $47,000 in dividends. At year-end 2003, the firms retained earnings totaled $1,048,000. The
firm had 140,000 shares of common stock outstanding during 2003.
CHAPTER 2
Financial Statements and Analysis
81
a. Prepare a statement of retained earnings for the year ended December 31,
2003, for Hayes Enterprises. (Note: Be sure to calculate and include the
amount of cash dividends paid in 2003.)
b. Calculate the firms 2003 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock during 2003?
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Changes in stockholders equity Listed are the equity sections of balance sheets
for years 2002 and 2003 as reported by Mountain Air Ski Resorts, Inc. The
overall value of stockholders equity has risen from $2,000,000 to $7,500,000.
Use the statements to discover how and why this happened.
Mountain Air Ski Resorts, Inc.
Balance Sheets (partial)
Stockholders Equity
2002
2003
Common stock ($1.00 par)
Authorized5,000,000 shares
Outstanding 1,500,000 shares 2003
500,000 shares 2002
$1,500,000
$ 500,000
Paid-in capital in excess of par
500,000
Retained earnings
4,500,000
1,000,000
1,500,000
$2,000,000
Total stockholders equity
$7,500,000
The company paid total dividends of $200,000 during fiscal 2003.
a. What was Mountain Airs net income for fiscal 2003?
b. How many new shares did the corporation issue and sell during the
year?
c. At what average price per share did the new stock sold during 2003 sell?
d. At what price per share did Mountain Airs original 500,000 shares sell?
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210
Ratio comparisons Robert Arias recently inherited a stock portfolio from his
uncle. Wishing to learn more about the companies that he is now invested in,
Robert performs a ratio analysis on each one and decides to compare them to
each other. Some of his ratios are listed below.
Island
Electric Utility
Burger
Heaven
Fink
Software
Roland
Motors
Current ratio
1.10
1.3
6.8
4.5
Quick ratio
0.90
0.82
5.2
3.7
Debt ratio
0.68
0.46
0
Net profit margin
6.2%
14.3%
Ratio
28.5%
0.35
8.4%
Assuming that his uncle was a wise investor who assembled the portfolio with
care, Robert finds the wide differences in these ratios confusing. Help him out.
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a. What problems might Robert encounter in comparing these companies to
one another on the basis of their ratios?
b. Why might the current and quick ratios for the electric utility and the
fast-food stock be so much lower than the same ratios for the other
companies?
c. Why might it be all right for the electric utility to carry a large amount of
debt, but not the software company?
d. Why wouldnt investors invest all of their money in software companies
instead of in less profitable companies? (Focus on risk and return.)
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Liquidity management Bauman Companys total current assets, total current
liabilities, and inventory for each of the past 4 years follow:
Item
2000
Total current assets
2001
2002
2003
$16,950
$21,900
$22,500
$27,000
Total current liabilities
9,000
12,600
12,600
17,400
Inventory
6,000
6,900
6,900
7,200
a. Calculate the firms current and quick ratios for each year. Compare the
resulting time series for these measures of liquidity.
b. Comment on the firms liquidity over the 20002003 period.
c. If you were told that Bauman Companys inventory turnover for each
year in the 20002003 period and the industry averages were as follows,
would this information support or conflict with your evaluation in part b?
Why?
Inventory turnover
2000
Bauman Company
212
2002
2003
6.3
6.8
7.0
6.4
10.6
Industry average
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2001
11.2
10.8
11.0
Inventory management Wilkins Manufacturing has sales of $4 million and a
gross profit margin of 40%. Its end-of-quarter inventories are
Quarter
Inventory
1
$ 400,000
2
800,000
3
1,200,000
4
200,000
a. Find the average quarterly inventory and use it to calculate the firms inventory turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory
turnover of 2.0, how would you evaluate the activity of Wilkins inventory?
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Financial Statements and Analysis
83
Accounts receivable management An evaluation of the books of Blair Supply,
which follows, gives the end-of-year accounts receivable balance, which is
believed to consist of amounts originating in the months indicated. The company
had annual sales of $2.4 million. The firm extends 30-day credit terms.
Month of origin
Amounts receivable
July
$ 3,875
August
2,000
September
34,025
October
15,100
November
52,000
December
193,000
Year-end accounts receivable
$300,000
a. Use the year-end total to evaluate the firms collection system.
b. If 70% of the firms sales occur between July and December, would this
affect the validity of your conclusion in part a? Explain.
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Interpreting liquidity and activity ratios The new owners of Bluegrass Natural
Foods, Inc., have hired you to help them diagnose and cure problems that the
company has had in maintaining adequate liquidity. As a first step, you perform
a liquidity analysis. You then do an analysis of the companys short-term activity
ratios. Your calculations and appropriate industry norms are listed.
Ratio
Bluegrass
Industry norm
Current ratio
4.5
4.0
Quick ratio
2.0
3.1
Inventory turnover
6.0
10.4
Average collection period
73 days
52 days
Average payment period
31 days
40 days
a. What recommendations relative to the amount and the handling of inventory
could you make to the new owners?
b. What recommendations relative to amount and handling of accounts receivable could you make to the new owners?
c. What recommendations relative to amount and handling of accounts payable
could you make to the new owners?
d. What results, overall, would you hope your recommendations would
achieve? Why might your recommendations not be effective?
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215
Debt analysis Springfield Bank is evaluating Creek Enterprises, which has
requested a $4,000,000 loan, to assess the firms financial leverage and financial
risk. On the basis of the debt ratios for Creek, along with the industry averages
and Creeks recent financial statements (which follow), evaluate and recommend
appropriate action on the loan request.
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Creek Enterprises
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$30,000,000
Less: Cost of goods sold
21,000,000
Gross profits
$ 9,000,000
Less: Operating expenses
Selling expense
$3,000,000
General and administrative expenses
Lease expense
1,800,000
200,000
Depreciation expense
1,000,000
Total operating expense
6,000,000
Operating profits
$ 3,000,000
Less: Interest expense
1,000,000
Net profits before taxes
$ 2,000,000
800,000
Less: Taxes (rate = 40%)
Net profits after taxes
$ 1,200,000
Less: Preferred stock dividends
Earnings available for common stockholders
100,000
$ 1,100,000
Creek Enterprises
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders Equity
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Current liabilities
$ 1,000,000
3,000,000
12,000,000
7,500,000
$23,500,000
Gross fixed assets (at cost)a
Land and buildings
Machinery and equipment
Furniture and fixtures
Gross fixed assets
Less: Accumulated depreciation
$ 8,000,000
Notes payable
8,000,000
Accruals
Total current liabilities
Long-term debt (includes financial leases)b
500,000
$16,500,000
$20,000,000
Stockholders equity
$11,000,000
20,500,000
8,000,000
$39,500,000
13,000,000
Net fixed assets
$26,500,000
Total assets
$50,000,000
aThe
Accounts payable
Preferred stock (25,000 shares,
$4 dividend)
$ 2,500,000
Common stock (1 million shares at $5 par)
5,000,000
Paid-in capital in excess of par value
4,000,000
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity
2,000,000
$13,500,000
$50,000,000
firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of the lease have yet to run.
annual principal payments are $800,000.
bRequired
Note: Industry averages appear at the top of the following page.
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Financial Statements and Analysis
85
Industry averages
Debt ratio
216
7.30
Fixed-payment coverage ratio
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0.51
Times interest earned ratio
1.85
Common-size statement analysis A common-size income statement for Creek
Enterprises 2002 operations follows. Using the firms 2003 income statement
presented in Problem 215, develop the 2003 common-size income statement
and compare it to the 2002 statement. Which areas require further analysis and
investigation?
Creek Enterprises
Common-size Income Statement
for the Year Ended December 31, 2002
Sales revenue ($35,000,000)
100.0%
Less: Cost of goods sold
65.9
Gross profits
34.1%
Less: Operating expenses
Selling expense
12.7%
General and administrative expenses
6.3
Lease expense
0.6
Depreciation expense
3.6
Total operating expense
23.2
Operating profits
10.9%
Less: Interest expense
1.5
Net profits before taxes
9.4%
Less: Taxes (rate
40%)
3.8
Net profits after taxes
5.6%
Less: Preferred stock dividends
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217
0.1
Earnings available for common stockholders
5.5%
The relationship between financial leverage and profitability Pelican Paper,
Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers.
Some financial statement values for each company follow. Use them in a ratio
analysis that compares their financial leverage and profitability.
Item
Total assets
Pelican Paper, Inc.
Timberland Forest, Inc.
$10,000,000
$10,000,000
Total equity (all common)
9,000,000
5,000,000
Total debt
1,000,000
5,000,000
100,000
500,000
Annual interest
Total sales
$25,000,000
$25,000,000
EBIT
6,250,000
6,250,000
Net income
3,690,000
3,450,000
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a. Calculate the following debt and coverage ratios for the two companies.
Discuss their financial risk and ability to cover the costs in relation to each
other.
(1) Debt ratio
(2) Times interest earned ratio
b. Calculate the following profitability ratios for the two companies. Discuss
their profitability relative to each other.
(1) Operating profit margin
(2) Net profit margin
(3) Return on total assets
(4) Return on common equity
c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberlands investors
undertake when they choose to purchase its stock instead of Pelicans?
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Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in
fiscal year 2003. Some ratios for the company are listed below. Use this information to determine the dollar values of various income statement and balance
sheet accounts as requested.
McDougal Printing, Inc.
Year Ended December 31, 2003
Sales
$40,000,000
Gross profit margin
80%
Operating profit margin
35%
Net profit margin
8%
Return on total assets
16%
Return on common equity
20%
Total asset turnover
Average collection period
2
62.2 days
Calculate values for the following:
a. Gross profits
b. Cost of goods sold
c. Operating profits
d. Operating expenses
e. Earnings available for common stockholders
f. Total assets
g. Total common stock equity
h. Accounts receivable
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Cross-sectional ratio analysis Use the following financial statements for Fox
Manufacturing Company for the year ended December 31, 2003, along with the
industry average ratios also given in what follows, to:
a. Prepare and interpret a complete ratio analysis of the firms 2003 operations.
b. Summarize your findings and make recommendations.
CHAPTER 2
Financial Statements and Analysis
Fox Manufacturing Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$600,000
Less: Cost of goods sold
460,000
Gross profits
$140,000
Less: Operating expenses
General and administrative expenses
Depreciation expense
$30,000
30,000
Total operating expense
Operating profits
60,000
$ 80,000
Less: Interest expense
Net profits before taxes
Less: Taxes
10,000
$ 70,000
27,100
Net profits after taxes (earnings available
for common stockholders)
Earnings per share (EPS)
$ 42,900
$2.15
Fox Manufacturing Company
Balance Sheet
December 31, 2003
Assets
Cash
Marketable securities
$ 15,000
7,200
Accounts receivable
34,100
Inventories
82,000
Total current assets
$138,300
Net fixed assets
$270,000
Total assets
$408,300
Liabilities and Stockholders Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
$ 57,000
13,000
5,000
$ 75,000
$150,000
Stockholders equity
Common stock equity (20,000 shares outstanding)
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity
$110,200
73,100
$183,300
$408,300
Note: Industry averages appear at the top of the following page.
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Ratio
Industry average, 2003
Current ratio
Quick ratio
Inventory turnover a
Average collection perioda
Total asset turnover
Debt ratio
Times interest earned ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets (ROA)
Return on common equity (ROE)
Earnings per share (EPS)
aBased
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220
2.35
0.87
4.55
35.3 days
1.09
0.300
12.3
0.202
0.135
0.091
0.099
0.167
$3.10
on a 360-day year and on end-of-year figures.
Financial statement analysis The financial statements of Zach Industries for the
year ended December 31, 2003, follow.
Zach Industries
Income Statement
for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Zach Industries
Balance Sheet
December 31, 2003
$160,000
106,000
$ 54,000
Less: Operating expenses
Selling expense
$ 16,000
General and administrative expenses
10,000
Lease expense
1,000
Depreciation expense
Total operating expense
Operating profits
10,000
$ 37,000
$ 17,000
Less: Interest expense
Net profits before taxes
6,100
$ 10,900
Less: Taxes
Net profits after taxes
4,360
$
Assets
Cash
Marketable securities
$
500
1,000
Accounts receivable
25,000
Inventories
45,500
Total current assets
Land
Buildings and equipment
Less: Accumulated depreciation
Net fixed assets
Total assets
$ 72,000
$ 26,000
90,000
38,000
$ 78,000
$150,000
Liabilities and Stockholders Equity
6,540
Accounts payable
Notes payable
Total current liabilities
$ 22,000
47,000
$ 69,000
Long-term debt
$ 22,950
Common stocka
$ 31,500
Retained earnings
$ 26,550
Total liabilities and stockholders equity
$150,000
aThe
firms 3,000 outstanding shares of common stock closed
2003 at a price of $25 per share.
CHAPTER 2
Financial Statements and Analysis
89
a. Use the preceding financial statements to complete the following table.
Assume that the industry averages given in the table are applicable for both
2002 and 2003.
Ratio
Industry
average
Actual 2002
Current ratio
Quick ratio
Inventory turnovera
Average collection perioda
Debt ratio
Times interest earned ratio
Gross profit margin
Net profit margin
Return on total assets
Return on common equity
Market/book ratio
1.80
0.70
2.50
37 days
65%
3.8
38%
3.5%
4.0%
9.5%
1.1
1.84
0.78
2.59
36 days
67%
4.0
40%
3.6%
4.0%
8.0%
1.2
aBased
Actual 2003
on a 360-day year and on end-of-year figures.
b. Analyze Zach Industries financial condition as it is related to (1) liquidity,
(2) activity, (3) debt, (4) profitability, and (5) market. Summarize the companys overall financial condition.
LG6
221
IntegrativeComplete ratio analysis Given the following financial statements,
historical ratios, and industry averages, calculate Sterling Companys financial
ratios for the most recent year. Analyze its overall financial situation from both
a cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firms liquidity, activity, debt, profitability, and market.
Sterling Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses
Selling expense
General and administrative expenses
Lease expense
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate = 40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share (EPS)
$10,000,000
7,500,000
$ 2,500,000
$300,000
650,000
50,000
200,000
1,200,000
$ 1,300,000
200,000
$ 1,100,000
440,000
$ 660,000
50,000
$ 610,000
$3.05
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PART 1
Introduction to Managerial Finance
Sterling Company
Balance Sheet
December 31, 2003
Assets
Liabilities and Stockholders Equity
Current assets
Current liabilities
Cash
$
200,000
Marketable securities
50,000
Accounts receivable
800,000
Inventories
950,000
Total current assets
Gross fixed assets (at
cost)a
Less: Accumulated depreciation
$ 2,000,000
$12,000,000
Accounts payableb
$
900,000
Notes payable
200,000
Accruals
100,000
Total current liabilities
$ 1,200,000
Long-term debt (includes financial leases)c
$ 3,000,000
Stockholders equity
3,000,000
Preferred stock (25,000 shares, $2 dividend)
Net fixed assets
$ 9,000,000
Other assets
$ 1,000,000
Paid-in capital in excess of par value
Total assets
$12,000,000
$ 1,000,000
Common stock (200,000 shares at $3 par)d
Retained earnings
600,000
5,200,000
1,000,000
Total stockholders equity
$ 7,800,000
Total liabilities and stockholders equity
$12,000,000
aThe
firm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run.
credit purchases of $6,200,000 were made during the year.
cThe annual principal payment on the long-term debt is $100,000.
dOn December 31, 2003, the firms common stock closed at $39.50 per share.
bAnnual
Historical and Industry Average Ratios for Sterling Company
Ratio
Actual 2001
Actual 2002
Industry average, 2003
Current ratio
1.40
1.55
1.85
Quick ratio
1.00
0.92
1.05
Inventory turnover
9.52
9.21
8.60
Average collection period
45.0 days
36.4 days
35.0 days
Average payment period
58.5 days
60.8 days
45.8 days
Total asset turnover
0.74
0.80
0.74
Debt ratio
0.20
0.20
0.30
Times interest earned ratio
8.2
7.3
8.0
Fixed-payment coverage ratio
4.5
4.2
4.2
Gross profit margin
0.30
0.27
0.25
Operating profit margin
0.12
0.12
0.10
Net profit margin
0.062
0.062
0.053
Return on total assets (ROA)
0.045
0.050
0.040
Return on common equity (ROE)
0.061
0.067
0.066
Earnings per share (EPS)
$1.75
$2.20
$1.50
Price/earnings (P/E) ratio
12.0
10.5
11.2
Market/book (M/B) ratio
1.20
1.05
1.10
CHAPTER 2
LG6
222
Financial Statements and Analysis
91
Dupont system of analysis Use the following ratio information for Johnson
International and the industry averages for Johnsons line of business to:
a. Construct the DuPont system of analysis for both Johnson and the
industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?
2001
2002
2003
Financial leverage multiplier
1.75
1.75
1.85
Net profit margin
0.059
0.058
0.049
Total asset turnover
2.11
2.18
2.34
Financial leverage multiplier
1.67
1.69
1.64
Net profit margin
0.054
0.047
0.041
Total asset turnover
2.05
2.13
2.15
Johnson
Industry Averages
LG6
223
Complete ratio analysis, recognizing significant differences Home Health, Inc.,
has come to Jane Ross for a yearly financial checkup. As a first step, Jane has
prepared a complete set of ratios for fiscal years 2002 and 2003. She will use
them to look for significant changes in the companys situation from one year to
the next.
Home Health, Inc.
Financial Ratios
Ratio
2002
2003
Current ratio
3.25
3.00
Quick ratio
2.50
2.20
Inventory turnover
12.80
10.30
Average collection period
42 days
31 days
Total asset turnover
1.40
2.00
Debt ratio
0.45
0.62
Times interest earned ratio
4.00
3.85
Gross profit margin
68%
65%
Operating profit margin
14%
16%
Net profit margin
8.3%
8.1%
Return on total assets
11.6%
16.2%
Return on common equity
21.1%
42.6%
Price/earnings ratio
10.7
Market/book ratio
1.40
9.8
1.25
92
PART 1
Introduction to Managerial Finance
a. In order to focus on the degree of change, calculate the year-to-year proportional change by subtracting the year 2002 ratio from the year 2003 ratio,
then dividing the difference by the year 2002 ratio. Multiply the result by
100. Preserve the positive or negative sign. The result is the percentage
change in the ratio from 2002 to 2003. Calculate the proportional change for
the ratios shown here.
b. For any ratio that shows a year-to-year difference of 10% or more, state
whether the difference is in the companys favor or not.
c. For the most significant changes (25% or more), look at the other ratios and
cite at least one other change that may have contributed to the change in the
ratio that you are discussing.
CHAPTER 2 CASE
Assessing Martin Manufacturings
Current Financial Position
T
erri Spiro, an experienced budget analyst at Martin Manufacturing
Company, has been charged with assessing the firms financial performance
during 2003 and its financial position at year-end 2003. To complete this assignment, she gathered the firms 2003 financial statements, which follow. In addition, Terri obtained the firms ratio values for 2001 and 2002, along with the
2003 industry average ratios (also applicable to 2001 and 2002). These are presented in the table on page 94.
Martin Manufacturing Company
Income Statement
for the Year Ended December 31, 2003
Sales revenue
$5,075,000
Less: Cost of goods sold
3,704,000
Gross profits
$1,371,000
Less: Operating expenses
Selling expense
$650,000
General and administrative expenses
416,000
Depreciation expense
152,000
Total operating expense
Operating profits
1,218,000
$ 153,000
Less: Interest expense
Net profits before taxes
Less: Taxes (rate
93,000
$
60,000
$
36,000
$
33,000
24,000
40%)
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share (EPS)
3,000
$0.33
CHAPTER 2
Financial Statements and Analysis
Martin Manufacturing Company
Balance Sheets
December 31
Assets
2003
2002
Current assets
Cash
$
Accounts receivable
Gross fixed assets (at cost)
$
24,100
763,900
700,625
763,445
$1,531,181
$1,551,445
$2,093,819
$1,691,707
Inventories
Total current assets
25,000
805,556
Less: Accumulated depreciation
500,000
348,000
Net fixed assets
$1,593,819
$1,343,707
Total assets
$3,125,000
$2,895,152
$ 230,000
$ 400,500
Liabilities and Stockholders Equity
Current liabilities
Accounts payable
Notes payable
311,000
Total current liabilities
Long-term debt
Total liabilities
370,000
75,000
Accruals
100,902
$ 616,000
$ 871,402
$1,165,250
$ 700,000
$1,781,250
$1,571,402
$
$
Stockholders equity
Preferred stock (2,500 shares, $1.20 dividend)
Common stock (100,000 shares at $4 par)a
50,000
400,000
50,000
400,000
Paid-in capital in excess of par value
593,750
593,750
Retained earnings
300,000
280,000
$1,343,750
$1,323,750
$3,125,000
$2,895,152
Total stockholders equity
Total liabilities and stockholders equity
aThe
firms 100,000 outstanding shares of common stock closed 2003 at a price of $11.38
per share.
Note: Industry historical ratios appear at the top of the following page.
93
94
PART 1
Introduction to Managerial Finance
Martin Manufacturing Company
Historical ratios
Ratio
Actual
2001
Actual
2002
Actual
2003
Industry average
2003
Current ratio
1.7
1.8
Quick ratio
1.0
0.9
1.2
Inventory turnover (times)
5.2
5.0
10.2
Average collection period
Total asset turnover (times)
Debt ratio
Times interest earned ratio
50 days
55 days
1.5
46 days
1.5
1.5
2.0
45.8%
54.3%
24.5%
2.2
1.9
2.5
27.5%
28.0%
26.0%
Net profit margin
1.1%
1.0%
1.2%
Return on total assets (ROA)
1.7%
1.5%
2.4%
Return on common equity (ROE)
3.1%
3.3%
Gross profit margin
3.2%
Price/earnings (P/E) ratio
33.5
38.7
43.4
Market/book (M/B) ratio
1.0
1.1
1.2
Required
a. Calculate the firms 2003 financial ratios, and then fill in the preceding table.
b. Analyze the firms current financial position from both a cross-sectional and
a time-series viewpoint. Break your analysis into evaluations of the firms
liquidity, activity, debt, profitability, and market.
c. Summarize the firms overall financial position on the basis of your findings
in part b.
WEB EXERCISE
WW
W
Go to Web site www.yahoo.com. On the left side of the Yahoo! home page
screen, click on the Finance category under Business and Economy. On the next
screen click on Y! Finance.
Using this screen, click on Symbol Lookup and find the symbol for Southwest Airlines. Click on this symbol to find the latest trading data for Southwest
Airlines.
1. What was the selling price for the last sale of Southwests common stock?
How much in dollars per share was the change?
2. What was the number of shares sold in this trade?
In the More Info box, you will see Profile. Click on it, and scroll down to Statistics at a Glance.
3. What was the amount of Southwests sales? What was its after-tax income?
4. What were Southwests earnings per share? What was its book value per
share?
CHAPTER 2
Financial Statements and Analysis
95
5. How many shares of stock does Southwest have outstanding?
6. What were the values of the following ratios for Southwest?
a. Current ratio
b. Operating profit margin
c. Debt/equity ratio
d. Return on equity
e. What other information would you need to evaluate Southwests financial performance on the basis of these ratios?
7. Find More from Market Guide and click on Ratio Comparisons. Using these
data, summarize Southwests performance.
Remember to check the books Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.