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Unformatted text preview: Analysis
of Financial
Statements
“Money is better than poverty, if only for
financial reasons.”
—Woody Allen
Financial Statements Tell the Story
On its website, The Scotts Company, headquartered in Ohio for more than
137 years, says it is the world’s leading supplier and marketer of consumer
products for doityourself lawn and garden care. Scotts’ brands include
MiracleGro®, the leading plant fertilizer. In its 2005 Annual Report, the
company adds that it is “dedicated to delivering strong, consistent financial
results and outstanding shareholder returns.”1
A few questions:
• On what basis does the company make the claim that it is the “leading” supplier
and marketer of lawn and gardencare products? • What does the company mean when it says MiracleGro® is the “leading” plant
fertilizer? • What constitutes “strong, consistent financial results?”
• How are “shareholder returns” measured and how high do they have to be to be
regarded as “outstanding?” The answers to these questions and more can be found by examining the
company’s financial statements. For example, by comparing Scotts’ income
statement and balance sheet with those of other companies, you could find
out whether the claim that Scotts is the “leading” company is based on its
sales, its profits, or its assets. A more indepth look at the statements would
reveal whether Scotts really does deliver strong, consistent financial results and
outstanding shareholder returns according to your own investment criteria.
Source: The Scotts company website (www.scotts.com) and 2005 Annual Report, page 21. 1 92 © Jostein Hauge (http://www.fotolia.com/p/3937 ) Financial statements are like puzzles. When you first look at them, many
questions arise. What does the picture look like? How do the pieces fit
together? What is a company doing? How are they doing it? As the puzzle
is assembled, however, the facts begin to surface. This is what the company
did. This is how they did it. This is where the money came from. This is where
it went. When the puzzle is complete, the company’s financial picture lies
before you, and with that picture you can make sound judgments about
the company’s profitability, liquidity, debt management, and market value. Chapter Overview
In Chapter 4 we reviewed the major financial statements, the primary sources
of financial information about a business. In this chapter we will learn how
to interpret these financial statements in greater detail. All business owners,
investors, and creditors use financial statements and ratio analysis to investigate
the financial health of a firm. We will see how financial managers calculate ratios
that measure profitability, liquidity, debt, asset activity, and market performance
of a firm. We will then explore how financial experts use ratios to compare a firm’s
performance to managers’ goals, the firm’s past and present performance, and the
firm’s performance to similar firms in the industry. We will also discuss sources
of financial information. 93 Learning Objectives
After reading this chapter,
you should be able to:
1. Explain how financial ratio
analysis helps financial
managers assess the health
of a company.
2. Compute profitability,
liquidity, debt, asset
utilization, and market
value ratios.
3. Compare financial
information over time and
among companies.
4. Locate ratio value data for
specific companies and
industries. 94 Part II Essential Concepts in Finance Assessing Financial Health
Medical doctors assess the health of people. Financial managers assess the health of
businesses. When you visit a doctor for an examination, the doctor may check your
blood pressure, heart rate, cholesterol, and blood sugar levels. The results of each test
should fall within a range of numbers considered “normal” for your age, weight, gender,
and height. If they don’t, the doctor will probably run additional tests to see what, if
anything, is wrong.
Like doctors, financial managers check the health of businesses by running basic
tests—such as a financial ratio analysis—to see whether a firm’s performance is within
the normal range for a company of that type. If it is not, the financial manager runs more
tests to see what, if anything, is wrong. Misleading Numbers
Both medical doctors and financial managers must interpret the information they have
and decide what additional information they need to complete an analysis. For instance,
suppose a doctor examines a sixfoot, 230pound, 22yearold male named Dirk. The
doctor’s chart shows that a healthy male of that age and height should normally weigh
between 160 and 180 pounds. Because excess weight is a health risk, the numbers don’t
look positive.
Before the doctor prescribes a diet and exercise program for Dirk, she asks followup
questions and runs more tests. She learns that Dirk, a starting fullback for his college
football team, has only 6 percent body fat, can benchpress 380 pounds, runs a 40yard
dash in 4.5 seconds, has a blood pressure rate of 110/65, and a resting heart rate of 52 beats
per minute. This additional information changes the doctor’s initial health assessment.
Relying on incomplete information would have led to an inaccurate diagnosis.
Like doctors, financial managers need to analyze many factors to determine the
health of a company. Indeed, for some firms the financial statements do not provide
the entire picture.
In 1998 the attorneys general of many states sued the major tobacco companies
alleging liability for smokingrelated illness and for advertising allegedly aimed at
underage people. Congress also was seeking legislation that would extract hundreds
of billions of dollars over several years from these companies. Because the outcome
of the pending lawsuits and legislation was uncertain, the (potential) liabilities did not
appear on the balance sheet. Financial analysis based only on the financial statements,
then, gave a faulty impression of the companies’ health.
As the tobacco company example demonstrates, accounting conventions may prevent
factors affecting a firm’s finances from appearing on financial statements. Just as Dirk’s
doctor looked beyond the obvious, financial managers using ratio analysis must always
seek complete information before completing an analysis. In the sections that follow,
we discuss ratios based on financial statements, ratios that use market information, and
outside information sources.
Financial Ratios
Financial managers use ratio analysis to interpret the raw numbers on financial
statements. A financial ratio is a number that expresses the value of one financial
variable relative to another. Put more simply, a financial ratio is the result you get when Chapter 5 Analysis of Financial Statements you divide one financial number by another. Calculating an individual ratio is simple,
but each ratio must be analyzed carefully to effectively measure a firm’s performance.
Ratios are comparative measures. Because the ratios show relative value, they
allow financial analysts to compare information that could not be compared in its raw
form.2 Ratios may be used to compare: • one ratio to a related ratio
• the firm’s performance to management’s goals
• the firm’s past and present performances
• the firm’s performance to similar firms
For instance, say a company reaped huge revenues from one investment, but the
cost of the investment was high. A financial manager could use a ratio to compare that
investment to another that did not generate such high revenues but had low cost. Take
the 1997 movie, Titanic, for example. That blockbuster movie has grossed more than
$1.8 billion to date (the numberone grossing movie of all time). Compare Titanic’s total
revenues to the $916 million in revenues that Shrek 2 has made since it was released in
2004. Looking only at the total revenue figures, Titanic looks like a better investment
than Shrek 2.
However, analysts in the movie industry use a returnoncost ratio (total revenues
divided by total cost) to find a movie’s net return per $1 invested. Using that ratio we see
that Titanic, at a cost of $200 million, had a returnoncost ratio of 9.0 ($1,800,000,000
÷ $200,000,000 = 9.0). Shrek 2, at a cost of $70 million, had a returnoncost ratio of
13.1 ($916,000,000 ÷ $70,000,000 = 13.1). Although Titanic made more total revenue,
Shrek 2 made more money relative to its cost than did Titanic.3
Financial managers, other business managers, creditors, and stockholders all use
financial ratio analysis. Specifically, creditors may use ratios to see whether a business
will have the cash flow to repay its debt and interest. Stockholders may use ratios to
see what the longterm value of their stock will be. For example, in the first quarter of
2006 Exxon Mobil reported a profit of $8.4 billion. However, analysts on Wall Street
had predicted that the company’s profits would be slightly higher than that, so despite
the reported profits, Exxon Mobil’s stock price fell $.20 a share.4 The Basic Financial Ratios
Financial ratios are generally divided into five categories: profitability, liquidity, debt,
asset activity, and market value. The ratios in each group give us insights into different
aspects of a firm’s financial health. • Profitability ratios measure how much company revenue is eaten up by expenses, how much a company earns relative to sales generated, and the amount earned relative to
the value of the firm’s assets and equity. Financial managers who analyze the financial condition of the firms they work for act as financial analysts. The term financial
analyst, however, also includes financial experts who analyze a variety of firms. 2 Source for movie profitability figures: http://www.thenumbers.com/movies/records/budgets.html. 3 www.Bloomberg.com, April 27, 2006. 4 95 96 Part II Essential Concepts in Finance • Liquidity ratios indicate how quickly and easily a company can obtain cash for
its needs. • Debt ratios measure how much a company owes to others.
• Asset activity ratios measure how efficiently a company uses its assets.
• Market value ratios measure how the market value of a company’s stock compares
with its accounting values. Calculating the Ratios
We will use the financial statements for the Acme Corporation presented in Chapter 4 as
the basis for our ratio analysis. Figure 51 shows Acme Corporation’s income statement
for 2009, and Figure 52 shows its December 31, 2009, balance sheet.
Now let’s analyze Acme Corporation’s financial health by calculating its profitability,
liquidity, debt, asset utilization, and market value ratios.
Profitability Ratios
Profitability ratios measure how the firm’s returns compare with its sales, asset
investments, and equity. Stockholders have a special interest in the profitability ratios
because profit ultimately leads to cash flow, a primary source of value for a firm.
Managers, acting on behalf of stockholders, also pay close attention to profitability
ratios to ensure that the managers preserve the firm’s value.
We will discuss five profitability ratios: gross profit margin, operating profit margin,
net profit margin, return on assets, and return on equity. Some of the profitability ratios
use figures from two different financial statements. Figure 51 Acme Corporation
Income Statement
for the Year Ended
December 31, 2009 Net Sales $15,000,000
5,000,000 Cost of Goods Sold
Gross Profit 10,000,000 Depreciation Expense 2,000,000 S&A Expenses 800,000 Operating Income (EBIT) 7,200,000 Interest Expense 1,710,000 Income before Taxes 5,490,000 Income Taxes 2,306,000 Net Income $ 3,184,000 Earnings per Share (4,000,000 shares) $ 0.80 Dividends Paid $ 400,000 Change in Retained Earnings $ 2,784,000 Chapter 5 97 Analysis of Financial Statements Acme Corporation Balance Sheet
For the Year Ended December 31, 2009
Assets:
Cash $ 10,000,000 Marketable Securities 8,000,000
1,000,000 Accounts Receivable
Inventory 10,000,000
1,000,000 Prepaid Expenses
Total Current Assets 30,000,000 Fixed Assets, Gross 28,000,000
(8,000,000 ) Less Accumulated Depreciation 20,000,000
Fixed Assets, Net $ 50,000,00 Total Assets
Liabilities and Equity: $ 4,000,000 Accounts Payable
Notes Payable 3,000,000 Accrued Expenses 2,000,000
9,000,000 Total Current Liabilities
LongTerm Debt 15,000,000 Total Liabilities 24,000,000 Common Stock ($1 par) 4,000,000 Capital in Excess of Par 12,000,000 Retained Earnings 10,000,000 Total Common Equity 26,000,000 Total Liabilities and Equity $ 50,000,000 Gross Profit Margin The gross profit margin measures how much profit remains out of
each sales dollar after the cost of the goods sold is subtracted. The ratio formula follows:
Gross Profit Margin =
= Gross Profit
Sales
$10, 000, 000
= .67, or 67%
$15, 000, 000 This ratio shows how well a firm generates revenue compared with its costs of
goods sold. The higher the ratio, the better the cost controls compared with the sales
revenues.
To find the gross profit margin ratio for Acme, look at Figure 51, Acme’s income
statement. We see that Acme’s gross profit for the year was $10 million and its sales
revenue was $15 million. Dividing $10 million by $15 million yields Acme Corporation’s
gross profit margin of .67 or 67 percent. That ratio shows that Acme’s cost of products
and services sold was 33 percent of sales revenue, leaving the company with 67 percent
of sales revenue to use for other purposes. Figure 52 Acme
Corporation Statement
of Retained Earnings for
the Year Ended
December 31, 2009 98 Part II Essential Concepts in Finance Operating Profit Margin The operating profit margin measures how much profit
remains out of each sales dollar after all the operating expenses are subtracted. This
ratio is calculated by dividing earnings before interest and taxes (EBIT or operating
income) by sales revenue.
Operating Profit Margin =
= EBIT
Sales
$7, 200, 000
= .48, or 48%
$15, 000, 000 Acme’s EBIT, as shown on its income statement (see Figure 51), is $7,200,000.
Dividing $7.2 million by its sales revenue of $15 million gives an operating profit
margin of 48 percent (7,200,000 ÷ 15,000,000 = .48 or 48%). Acme’s operating profit
margin indicates that 48 percent of its sales revenues remain after subtracting all
operating expenses.
Net Profit Margin The net profit margin ratio measures how much profit out of each
sales dollar is left after all expenses are subtracted—that is, after all operating expenses,
interest, and income tax expense are subtracted. It is computed by dividing net income
by sales revenue. Acme’s net income for the year 2009 was $3.184 million. Dividing
$3.184 million by $15 million in sales yields a 21.2 percent net profit margin. Here’s
the computation:
Net Profit Margin =
= Net Income
Sales
$3,184, 000
= .212, or 21.2%
$15, 000, 000 Net income and the net profit margin ratio are often referred to as “bottomline”
measures. The net profit margin includes adjustments for nonoperating expenses, such
as interest and taxes, and operating expenses. We see that in 2009 Acme Corporation
had just over 21 percent of each sales dollar remaining after all expenses were paid.
Return on Assets The return on assets (ROA) ratio indicates how much income each
dollar of assets produces on average. It shows whether the business is employing its assets
effectively. The ROA ratio is calculated by dividing net earnings available to common
stockholders by the total assets of the firm. For Acme Corporation, we calculate this ratio
by dividing $3.184 million in net income (see Figure 51, Acme income statement) by
$50 million of total assets (see Figure 52, Acme balance sheet), for a return on assets
(ROA) of 6.4 percent. Here’s the calculation:
Return on Assets =
= Net Income
Total Assets
$3,184, 000
= .064, or 6.4%
$50, 000, 000 Chapter 5 Analysis of Financial Statements 99 In 2009, each dollar of Acme Corporation’s assets produced, on average, income of
just over $.06. Although this return on assets figure may seem low, it is not unusual for
certain types of companies, such as commercial banks, to have low ROA ratios. This is
because such firms are asset intensive and therefore the denominator of the ROA ratio
is large relative to the numerator.
Return on Equity The return on equity (ROE) ratio measures the average return
on the firm’s capital contributions from its owners (for a corporation, that means the
contributions of common stockholders). It indicates how many dollars of income were
produced for each dollar invested by the common stockholders.
ROE is calculated by dividing net income by common stockholders’ equity. To
calculate ROE for Acme Corporation, divide $3.184 million in net income by $26 million
in total common stockholders’ equity (see Figure 52, Acme balance statement). Acme’s
ROE is 12.2 percent, shown as follows:
Return on Equity =
= Net Income
Common Stockholders Equity
$3,184, 000
= .122, or 12.2%
$26, 000, 000 The ROE figure shows that in 2009 Acme Corporation returned, on average,
12.2 percent for every dollar that common stockholders invested in the firm.
Mixing Numbers from Income Statements and Balance Sheets When financial
managers calculate the gross profit margin, operating profit margin, and net profit
margin ratios, they use only income statement variables. In contrast, analysts use both
income statement and balance sheet variables to find the return on assets and return
on equity ratios. A mixed ratio is a ratio that uses both income statement and balance
sheet variables as inputs.
Because income statement variables show values over a period of time and balance
sheet variables show values for one moment in time, using mixed ratios poses the question
of how to deal with the different time dimensions. For example, should the analyst select
balance sheet variable values from the beginning, the end, or the midpoint of the year?
If there is a large change in the balance sheet account during the year, the choice could
make a big difference. Consider the following situation:
Total Assets Jan 1, 2009 $ 1,000,000 Total Assets Dec 31, 2009 $ 2,000,000 Net Income in 2009 $ Return on assets based on January 1 balance sheet:
$100,000/$1,000,000 = .10, or 10% Return on assets based on December 31 balance sheet:
$100,000/$2,000,000 = .05, or 5% 100,000 Take Note
Do not confuse the ROE
ratio with the return
earned by the individual
common stockholders
on their common stock
investment. The changes
in the market price of
the stock and dividends
received determine
the total return on an
individual’s common stock
investment. 100 Part II Essential Concepts in Finance Which figure is correct? There is no blackandwhite answer to this problem. Some
analysts add the beginningoftheyear balance sheet figure to the endoftheyear figure
and divide by two to get an average figure.
Logic and common sense suggest that analysts should pick figures that best match the
returns to the assets or to the equity. Say that Acme purchased a large amount of assets
early in the year. The middle or endofyear balance sheet figures would probably match
the returns to the assets more effectively than beginningoftheyear figures because
assets can only affect profit if they have been used. For simplicity, we used endofyear
balance sheet figures to calculate Acme’s mixed profitability ratios. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its shortterm obligations. These
ratios are important because failure to pay such obligations can lead to bankruptcy.
Bankers and other lenders use liquidity ratios to see whether to extend shortterm credit
to a firm. Generally, the higher the liquidity ratio, the more able a firm is to pay its
shortterm obligations. Stockholders, however, use liquidity ratios to see how the firm
has invested in assets. Too much investment in current—as compared with longterm—
assets indicates inefficiency. The interpretation of liquidity ratio values depends on who
is doing the analysis. A banker would likely never see a liquidity ratio value she would
view as too high. Very high values might make a stockholder, on the other hand, wonder
why more resources were not devoted to higher returning fixed assets instead of more
liquid but lower returning current assets.
The two main liquidity ratios are the current ratio and the quick ratio.
The Current Ratio The current ratio compares all the current assets of the firm (cash
and other assets that can be quickly and easily converted to cash) with all the company’s
current liabilities (liabilities that must be paid with cash soon). At the end of 2009,
Acme Corporation’s current assets were $30 million and its current liabilities were $9
million. Dividing Acme’s current assets by its current liabilities, as follows, we see that:
Current Ratio =
= Current Assets
Current Liabilities
$30, 000, 000
= 3.33
$9, 000, 000 Acme’s current ratio value, then, is 3.33. The ratio result shows that Acme has $3.33
of current assets for every dollar of current liabilities, indicating that Acme could pay
all its shortterm debts by liquidating about a third of its current assets.
The Quick Ratio The quick ratio is similar to the current ratio but is a more rigorous
measure of liquidity because it excludes inventory from current assets. To calculate the
quick ratio, then, divide current assets less inventory by current liabilities.
Quick Ratio =
= Current Assets Less Inventory
Current Liabilities
($30, 000, 000 − $10, 000, 000)
= 2.22
$9, 000, 000 Chapter 5 Analysis of Financial Statements This more conservative measure of a firm’s liquidity may be useful for some
businesses. To illustrate, suppose a computer retail store had a large inventory of personal
computers with outofdate Intel Pentium III® microprocessors. The computer store
would have a tough time selling its inventory for much money.
At the end of 2009, the balance sheet figures show that Acme Corporation’s current
assets less inventory are worth $20 million ($30,000,000 – $10,000,000). Its current
liabilities are $9 million. Dividing $20 million by $9 million, we see that its quick ratio
is 2.22. A quick ratio of 2.22 means that Acme could pay off 222 percent of its current
liabilities by liquidating its current assets, excluding inventory.
If Acme Corporation’s inventory is hard to liquidate, the quick ratio is more
important. If the company being analyzed had very liquid inventory, such as a government
securities dealer, the quick ratio would not be a useful analysis tool compared with the
current ratio. Debt Ratios
Financial analysts use debt ratios to assess the relative size of a firm’s debt load and
the firm’s ability to pay off the debt. The three primary debt ratios are the debt to total
assets, debt to equity, and times interest earned ratios.
Current and potential lenders of longterm funds, such as banks and bondholders, are
interested in debt ratios. When a business’s debt ratios increase significantly, bondholder
and lender risk increases because more creditors compete for that firm’s resources if the
company runs into financial trouble. Stockholders are also concerned with the amount
of debt a business has because bondholders are paid before stockholders.
The optimal debt ratio depends on many factors, including the type of business and
the amount of risk lenders and stockholders will tolerate. Generally, a profitable firm
in a stable business can handle more debt—and a higher debt ratio—than a firm in a
volatile business that sometimes records losses on its income statement.
Debt to Total Assets The debt to total assets ratio measures the percentage of the
firm’s assets that is financed with debt. Acme Corporation’s total debt at the end of
2009 was $24 million. Its total assets were $50 million. The calculations for the debt
to total assets ratio follow:
Debt to Total Assets =
= Total Debt
Total Assets
$24, 000, 000
= .48, or 48%
$50, 000, 000 Acme’s debt to total assets ratio value is 48 percent, indicating that the other 52
percent of financing came from equity investors (the common stockholders).
Times Interest Earned The times interest earned ratio is often used to assess a
company’s ability to service the interest on its debt with operating income from the
current period. The times interest earned ratio is equal to earnings before interest and
taxes (EBIT) divided by interest expense. Acme Corporation has EBIT of $7.2 million
and interest expense of $1.71 million for 2009. Acme’s times interest earned ratio is
as follows: 101 102 Part II Essential Concepts in Finance Times Interest Earned =
= EBIT
Interest Expense
$7, 200, 000
= 4.2
$1, 710, 000 Acme’s times interest earned ratio value of 4.2 means that the company earned $4.20
of operating income (EBIT) for each $1 of interest expense incurred during that year.
A high times interest earned ratio suggests that the company will have ample
operating income to cover its interest expense. A low ratio signals that the company may
have insufficient operating income to pay interest as it becomes due. If so, the business
might need to liquidate assets, or raise new debt or equity funds to pay the interest due.
Recall, however, that operating income is not the same as cash flow. Operating income
figures do not show the amount of cash available to pay interest. Because interest
payments are made with cash, the times interest earned ratio is only a rough measure
of a firm’s ability to pay interest with current funds. Asset Activity Ratios
Financial analysts use asset activity ratios to measure how efficiently a firm uses its
assets. They analyze specific assets and classes of assets. The three asset activity ratios
we’ll examine here are the average collection period (for accounts receivable), the
inventory turnover, and the total asset turnover ratios.
Average Collection Period The average collection period ratio measures how many
days, on average, the company’s credit customers take to pay their accounts. Managers,
especially credit managers, use this ratio to decide to whom the firm should extend
credit. Slow payers are not welcome customers.
To calculate the average collection period, divide accounts receivable by the
company’s average credit sales per day. (This in turn, is the company’s annual credit
sales divided by the number of days in a year, 365.)
Average Collection Period = Accounts Receivable
Average Daily Credit Sales = $1, 000, 000
($15, 000, 000 / 365) = $1, 000, 000
= 24.3 days
$41, 096 Acme Corporation had $1 million in accounts receivable and average daily credit
sales of $41,096 (i.e., $15 million total credit sales divided by 365 days in one year).
Dividing $1 million by $41,096 gives a value of 24.3. The ratio shows that in 2009 Acme
Corporation’s credit customers took an average of 24.3 days to pay their account balances.
Notice that, in calculating the ratio, we used Acme Corporation’s total sales figure
for 2009 in the denominator, assuming that all of Acme’s sales for the year were made
on credit. We made no attempt to break down Acme’s sales into cash sales and credit
sales. Financial analysts usually calculate this ratio using the total sales figure when
they do not have the creditsalesonly figure. Chapter 5 Analysis of Financial Statements Inventory Turnover The inventory turnover ratio tells us how efficiently the firm
converts inventory to sales. If the company has inventory that sells well, the ratio value
will be high. If the inventory does not sell well due to lack of demand or if there is
excess inventory, the ratio value will be low.
The inventory turnover formula follows:
Inventory Turnover =
= Sales
Inventory
$15, 000, 000
= 1.5
$10, 000, 000 Acme Corporation had sales of $15 million and inventory of $10 million in 2009.
Dividing $15 million by $10 million, we see that the inventory turnover value is 1.5.
This number means that in 2009 Acme “turned” its inventory into sales 1.5 times during
the year.5
Total Asset Turnover The total asset turnover ratio measures how efficiently a
firm utilizes its assets. Stockholders, bondholders, and managers know that the more
efficiently the firm operates, the better the returns.
If a company has many assets that do not help generate sales (such as fancy offices
and corporate jets for senior management), then the total asset turnover ratio will be
relatively low. A company with a high asset turnover ratio suggests that its assets help
promote sales revenue.
To calculate the asset turnover ratio for Acme, divide sales by total assets as follows:
Total Asset Turnover =
= Sales
Total Assets
$15, 000, 000
= .30, or 30%
$50, 000, 000 The 2009 total asset turnover ratio for Acme Corporation is its sales of $15 million
divided by its total assets of $50 million. The result is .30, indicating that Acme’s sales
were 30 percent of its assets. Put another way, the dollar amount of sales was 30 percent
of the dollar amount of its assets. Market Value Ratios
The ratios examined so far rely on financial statement figures. But market value ratios
mainly rely on financial marketplace data, such as the market price of a company’s
common stock. Market value ratios measure the market’s perception of the future earning
power of a company, as reflected in the stock share price. The two market value ratios
we discuss are the price to earnings ratio and the market to book value ratio. Many financial analysts define the inventory turnover ratio using cost of goods sold instead of sales in the numerator. They use
cost of goods sold because sales is defined in terms of sales price and inventory is defined in terms of cost. We will use sales in
the numerator of the inventory turnover ratio to be consistent with the other turnover ratios. 5 103 104 Part II Essential Concepts in Finance Price to Earnings Ratio The price to earnings (P/E) ratio is defined as:
P/ E Ratio = Market Price per Share
Earnings per Share To calculate earnings per share (EPS), we divide net income by the number of shares
of common stock outstanding.
Investors and managers use the P/E ratio to gauge the future prospects of a company.
The ratio measures how much investors are willing to pay for claim to one dollar of
the earnings per share of the firm. The more investors are willing to pay over the value
of EPS for the stock, the more confidence they are displaying about the firm’s future
growth—that is, the higher the P/E ratio, the higher are investors’ growth expectations.
Consider the following marketplace data for Acme:
Current Market Price of Acme Corporation’s Stock: $20.00 2009 EPS $0.80 P/ E Ratio =
= Market Price per Share
Earnings per Share
$20
= 25
$0.80 We see that the $20 per share market price of Acme Corporation’s common stock is
25 times the level of its 2009 earnings per share ($0.80 EPS). The result of 25 indicates
that stock traders predict that Acme has some growth in its future. It would take 25
years, at Acme’s 2009 earnings rate, for the company to accumulate net profits of $20
per share, the amount an investor would pay today to buy this stock.
Market to Book Value The market to book value (M/B) ratio is the market price per
share of a company’s common stock divided by the accounting book value per share
(BPS) ratio. The book value per share ratio is the amount of common stock equity on
the firm’s balance sheet divided by the number of common shares outstanding.
The book value per share is a proxy for the amount remaining per share after selling
the firm’s assets for their balance sheet values and paying the debt owed to all creditors
and preferred stockholders. We calculate Acme’s BPS ratio, based on the following
information:
Total Common Stock Equity at YearEnd 2009: $ 26,000,000 Number of Common Shares Outstanding: ÷ 4,000,000 Book Value per Share = $6.50 Now that we know the book value per share of Acme’s stock is $6.50, we can find
the market to book value ratio as follows:
Market to Book Value Ratio =
= Market Price per Share
Book Value per Share
$20
= 3.1
$6.50 Chapter 5 Analysis of Financial Statements We see that Acme’s M/B ratio is 3.1. That value indicates that the market price of
Acme common stock ($20) is 3.1 times its book value per share ($6.50).
When the market price per share of stock is greater than the book value per share,
analysts often conclude that the market believes the companys future earnings are worth
more than the firm’s liquidation value. The value of the firm’s future earnings minus
the liquidation value is the going concern value of the firm. The higher the M/B ratio,
when it is greater than 1, the greater the going concern value of the company seems to
be. In our case, Acme seems to have positive going concern value.
Companies that have a market to book value of less than 1 are sometimes considered
to be “worth more dead than alive.” Such an M/B ratio suggests that if the company
liquidated and paid off all creditors, it would have more left over for the common
stockholders than what the common stock could be sold for in the marketplace.
The M/B ratio is useful, but it is only a rough approximation of how liquidation and
going concern values compare. This is because the M/B ratio uses an accountingbased
book value. The actual liquidation value of a firm is likely to be different than the book
value. For instance, the assets of the firm may be worth more or less than the value
at which they are currently carried on the company’s balance sheet. In addition, the
current market price of the company’s bonds and preferred stock may also differ from
the accounting value of these claims. Economic Value Added and Market Value Added
Two new financial indicators that have become popular are economic value added (EVA)
and market value added (MVA). These indicators were developed by Stern Stewart &
Company, a consulting firm in New York City. EVA is a measure of the amount of profit
remaining after accounting for the return expected by the firm’s investors, whereas
MVA compares the firm’s current value with the amount the current owners paid for it.
According to Stern Stewart, the use of the EVA and MVA indicators can help add value
to a company because they help managers focus on rewards to stockholders instead
of traditional accounting measures.6 In the following paragraphs we discuss EVA and
MVA individually.
Economic Value Added (EVA) As we mentioned previously, EVA is a measure of
the amount of profit remaining after accounting for the return expected by the firm’s
investors. As such, EVA is said to be an “estimate of true economic profit, or the amount
by which earnings exceed or fall short of the required minimum rate of return investors
could get investing in other securities of comparable risk.”7 The formula to calculate
EVA is as follows:
EVA = EBIT(1 – TR) – (IC × Ka) where EBIT = earnings before interest and taxes
(i.e., operating income)
TR = the effective or average income tax rate
IC = invested capital (explained later)
Ka = investors’ required rate of return on their
investment (explained later)
http://www.sternstewart.com 6 Ibid. 7 105 106 Part II Essential Concepts in Finance Invested capital (IC) is the total amount of capital invested in the company. It is
the sum of the market values of the firm’s equity and debt capital. Ka is the weighted
average of the rates of return expected by the suppliers of the firm’s capital, sometimes
called the weighted average cost of capital, or WACC.
To illustrate how EVA is calculated, assume Acme’s common stock is currently
selling for $20 a share, and the weighted average return expected by investors (Ka) is
12 percent. Also assume that the book value of debt on Acme’s balance sheet is the
same as the market values.8 Also recall from Figures 51 and 52 that Acme’s EBIT for
2009 is $7,200,000; its effective income tax rate is 42 percent; and there are 4 million
shares of common stock outstanding.
The last term we need before calculating Acme’s EVA is invested capital (IC).
Remember it is the sum of the market values of the firm’s equity and debt capital.
Acme’s IC is found as follows:
Market Value of Common Equity = 4,000,000 shares × $20
= $80,000,000
Market Value of Debt Capital = Book Value
= Notes Payable + LongTerm Debt9
= $3,000,000 + $15,000,000
= $18,000,000
Total Invested Capital (IC) = $80,000,000 + $18,000,000
= $98,000,000 Now we have all the amounts necessary to solve the EVA equation for Acme in 2009:
EVA = EBIT(1 – TR) – (IC × Ka)
EVA = $7,200,000(1 – .42) – ($98,000,000 × .12)
EVA = $4,176,000 – $11,760,000
EVA = $(7,584,000) Acme’s EVA for 2009 is negative, indicating the company did not earn a sufficient
amount during the year to provide the return expected by all those who contributed capital
to the firm. Even though Acme had $7,200,000 of operating income and $3,184,000
of net income in 2009, it was not enough to provide the 12 percent return expected by
Acme’s creditors and stockholders.
Does the negative EVA result for 2009 indicate that Acme is in trouble? Not
necessarily. Remember the negative result is only for one year, whereas it is the trend
over the long term that counts. The negative result for this year could be due to any This assumption is frequently made in financial analysis to ease the difficulties of locating current market prices for debt
securities. Because prices of debt securities do not tend to fluctuate widely, the assumption does not generally introduce an
excessive amount of error into the EVA calculation. 8 Take note that total debt capital is not the same as total liabilities. Liabilities that are spontaneously generated, such as accounts
payable and accrued expenses, are not generally included in the definition of debt capital. True debt capital is created when a
specified amount of money is lent to the firm at a specified interest rate. 9 Chapter 5 Analysis of Financial Statements number of factors, all of which might be approved of by the creditors and stockholders.
As long as Acme’s average EVA over time is positive, occasional negative years are not
cause for alarm.
Market Value Added (MVA) Market value added (MVA) is the market value of invested
capital (IC), minus the book value of IC.10 MVA is similar to the market to book ratio
(M/B). MVA focuses on total market value and total invested capital, whereas M/B
focuses on the per share stock price and per share book value. The two measures are
highly correlated.
For Acme in 2009:
MVA = market value of debt plus equity – book value debt plus equity
MVA = ($18,000,000 + $80,000,000) – ($18,000,000 + $26,000,000)11
MVA = $98,000,000 – $44,000,000
MVA = $54,000,000 Companies that consistently have high EVAs would normally have a positive MVA.
If a company consistently has negative EVAs, it should have a negative MVA too.
In this section we examined the key profitability, liquidity, debt, asset activity, and
market value ratios. The value of each ratio tells part of the story about the financial
health of the firm. Next we explore relationships among ratios. Relationships among Ratios: The Du Pont System
As we discussed earlier, ratios may be used to compare one ratio to another related
ratio. Financial analysts compare related ratios to see what specific activities add to or
detract from a firm’s performance.
The Du Pont system of ratio analysis is named for the company whose managers
developed the general system. It first examines the relationships between net income
relative to sales and sales relative to total assets. The product of the net profit margin
and the total asset turnover is the return on assets (or ROA). This equation, known as
the Du Pont equation, follows:
Du Pont Equation
Return on Assets = Net Profit Margin × Total Asset Turnover
Net Income
Net Income
Sales
=
×
Total Assets
Sales
Total Assets (51) Sales, on the right side of the equation, appears in the denominator of the net profit
margin and in the numerator of the total asset turnover. These two equal sales figures
would cancel each other out if the equation were simplified, leaving net income over
total assets on the right. This, of course, equals net income over total assets, which is
on the left side of the equal sign, indicating that the equation is valid. 10
Notice that if you make the simplifying assumption (as we have been doing) that the market value of debt capital equals the
book value of debt capital, then the formula for MVA becomes the market value of equity minus the book value of equity.. Here again we assume the market value of debt equals the book value of debt. 11 107 108 Part II Essential Concepts in Finance This version of the Du Pont equation helps us analyze factors that contribute to a
firm’s return on assets. For example, we already know from our basic ratio analysis that
Acme Corporation’s return on assets for 2009 was 6.4 percent. Now suppose you wanted
to know how much of that 6.4 percent was the result of Acme’s net profit margin for
2009, and how much was the result of the activity of Acme’s assets in 2009. Equation
51, the Du Pont equation, provides the following answer:
Return on Assets = Net Profit Margin × Total Asset Turnover
Net Income
Net Income
Sales
=
×
Total Assets
Sales
Total Assets
.064 = $3,184, 000
$15, 000, 000
×
$15, 000, 000
$50, 000, 000 .064 = .212 × .3
or
6.4% = 21.2% × .3 Acme Corporation, we see, has a fairly healthy net profit margin, 21.2 percent,
but its total asset turnover is only threetenths its sales. The .3 total asset turnover has
the effect of cutting the 21.2 percent net profit margin by twothirds, such that ROA is
only 6.4 percent.
We might see a low total asset turnover and high net profit margin in a jewelry
store, where few items are sold each day but high profit is made on each item sold. A
grocery store, however, would have a low net profit margin and a high total asset turnover
because many items are sold each day but little profit is made on each dollar of sales.
Another version of the Du Pont equation, called the Modified Du Pont equation,
measures how the return on equity (ROE) is affected by net profit margin, asset activity,
and debt financing. As shown in Equation 52, in the modified Du Pont equation, ROE
is the product of net profit margin, total asset turnover, and the equity multiplier (the
ratio of total assets to common equity).
Modified Du Pont Equation
Return on Equity = Net Profit Margin Total Asset Turnover Equity Multiplier Net Income
Net Income
Sales
Total Assets
=
×
×
Common Stockholders’ Equity
Sales
Total Assets
Common Stockholders’ Equity (52) Notice that sales and total assets appear in both a numerator and a denominator
in the right side of the equation and would cancel out if the equation were simplified,
leaving net income over equity on both the right and the left of the equal sign, indicating
that the equation is valid. Chapter 5 Analysis of Financial Statements Solving the Modified Du Pont Equation for Acme Corporation in 2009 produces
the following:
Return on Equity = Net Profit Margin × Total Asset Turnover × Equity Multiplier
Net Income
Net Income
Sales
Total Assets
=
×
×
Common Stockholders’ Equity
Sales
Total Assets
Common Stockholders’ Equity
$3,184, 000
$3,184, 000
$15, 000, 000
$50, 000, 000
=
×
×
$26, 000, 000
$15, 000, 000
$50, 000, 000
$26, 000, 000
.122 = .212 × .3 × 1.9
or
12.2% = 21.2% × .3 × 1.9
*Note: The two sides of the equation do not exactly balance because of rounding. Examining the preceding equation, we see that Acme’s net profit margin of
21.2 percent is greater than its 12.2 percent ROE. However, Acme’s low productivity
of assets ($.30 in sales for every dollar of assets employed) reduces the effect of the
profit margin—21.2% × .3 = 6.4%. If no other factors were present, Acme’s ROE would
be 6.4 percent.
Now the equity multiplier comes into play. The equity multiplier indicates the
amount of financial leverage a firm has. A firm that uses only equity to finance its assets
should have an equity multiplier that equals 1.0. To arrive at this conclusion, recall the
basic accounting formula—total assets = liabilities + equity. If a firm had no debt on
its balance sheet, its liabilities would equal zero, so equity would equal total assets. If
equity equaled total assets, then the equity multiplier would be 1. Multiplying 1 times
any other number has no effect, so in such a situation ROE would depend solely on net
profit margin and total asset turnover.
If a firm does have debt on its balance sheet (as Acme does), it will have assets greater
than equity and the equity multiplier will be greater than 1. This produces a multiplier
effect that drives ROE higher (assuming net income is positive) than can otherwise be
accounted for by net profit margin and asset turnover.12
Acme’s equity multiplier of 1.9 indicates that Acme has assets that are 1.9 times
its equity. This has the effect (called the leverage effect) of boosting Acme’s return on
equity from 6.4 percent to 12.2 percent. The leverage effect, caused by debt of $24
million shown on Acme’s balance sheet, significantly alters Acme’s ROE. 12 We will discuss leverage in more detail in Chapter 13. 109 110 Interactive Module
Go to www.textbookmedia.
com and find the free
companion material for
this book. Then go to the
Interactive Spreadsheet
for chapter 5. Follow the
instructions there. What
do the ratios tell us? How
are the ratios connected?
Note how the numbers are
obtained from the financial
statements. Part II Essential Concepts in Finance In this section we reviewed basic ratios, and analyzed relationships of one ratio
to another to assess the firm’s financial condition. Next we will investigate how ratio
analysis can be used to compare trends in a firm’s performance and to compare the
firm’s performance to other firms in the same industry. Trend Analysis and Industry Comparisons
Ratios are used to compare a firm’s past and present performance and its industry
performance. In this section we will examine trend analysis and industry comparison.
Comparing a ratio for one year with the same ratio for other years is known as trend
analysis. Comparing a ratio for one company with the same ratio for other companies
in the same industry is industry comparison. Trend Analysis
Trend analysis helps financial managers and analysts see whether a company’s current
financial situation is improving or deteriorating. To prepare a trend analysis, compute
the ratio values for several time periods (usually years) and compare them. Table 51
shows a fiveyear trend for Acme Corporation’s ROA.
As Table 51 shows, Acme Corporation’s ROA rose substantially between 2006
and 2009, with the largest growth occurring between 2006 and 2007. Overall, the
trend analysis indicates that Acme’s 2009 ROA of 6.4 percent is positive, compared
to earlier years.
Usually, analysts plot ratio value trends on a graph to provide a picture of the results.
Figure 53, on the next page, is a graph of Acme’s 2005–2009 ROA ratios.
The fiveyear generally upward trend in ROA, depicted in Figure 53, indicates that
Acme Corporation increased the amount of profit it generated from its assets.
Trend analysis is an invaluable part of ratio analysis. It helps management spot a
deteriorating condition and take corrective action, or identify the company’s strengths.
By assessing the firm’s strengths and weaknesses, and the pace of change in a strength
or weakness, management can plan effectively for the future.
Industry Comparisons
Another way to judge whether a firm’s ratio is too high or too low is to compare it with
the ratios of other firms in the industry (this is sometimes called crosssectional analysis,
or benchmarking). This type of comparison pinpoints deviations from the norm that
may indicate problems.
Table 52 shows a comparison between Acme Corporation’s ROA ratio and the
average ROA in Acme Corporation’s industry for 2009. It shows that, compared with
other firms in Acme’s industry, Acme achieved an aboveaverage ROA in 2009. Only
Company B managed to do better than Acme.
Table 51 Acme Corporation ROA, 2005–2009
2005
ROA 2006 2007 2008 2009 –1.8% –2.2% 2.6% 4.1% 6.4% Chapter 5 111 Analysis of Financial Statements 8% 6% 4% 2% 0% –2% –4% 2005 2006 2007 2008 Figure 53 Acme
Corporation FiveYear
Trend in ROA 2009 Benchmarking allows analysts to put the value of a firm’s ratio in the context of
its industry. For example, Acme’s ROA of 6.4% is higher than average for its industry,
thus Acme would be looked upon favorably. In another industry, however, the average
ROA might be 10 percent, causing Acme’s 6.4% to appear much too low. Whether a
ratio value is good or bad depends on the characteristics of the industry. By putting the
ratio in context, analysts compare apples to apples and not apples to oranges.
Note—do not fall into the trap of thinking that a company does not have problems
just because its ratios are equal to the industry averages. Maybe the whole industry is
in a slump! When a ratio equals the industry average it simply means the company is
average in the area that ratio measures. Table 52 Acme Corporation CrossSectional Analysis of ROA 2009
Company ROA Acme Corporation 6.4% Company A 1.0% Company B 7.1% Company C 0.9% Industry Average 3.9% (ACME + A + B + C) ÷ 4 = 3.9 112 Part II Essential Concepts in Finance Summary Analysis: Trend and Industry
Comparisons Together
A complete ratio analysis of a company combines both trend analysis and industry
comparisons. Table 53 shows all the ratios presented in this chapter for Acme
Corporation for 2005 through 2009, along with the industry averages for those ratios.
(The industry averages are labeled IND in the table.)
First, let’s review Acme’s profitability ratios compared with the industry average
for 2005 to 2009. In 2005 and 2006, Acme Corporation had negative net income. This
gave a negative value to the net profit margin, return on assets, and return on equity
for each of these years (because net income is the numerator for each ratio). There was
steady improvement, however, in the profit ratios from 2005 to 2009.
Acme Corporation had lower gross profit, operating profit, and net profit margins
than the industry norm for that fiveyear time period except for the 2009 operating and
net profit margins. For 2005 and 2006, Acme also had a lower return on assets ratio
than the industry average. As the summary analysis shows, the 2005–2009 ROAs are
the result of higher asset turnover ratios.
The return on equity figures paint a telling story over this fiveyear period. From
2005 to 2007, Acme Corporation had a much lower return on equity than the average
firm in its industry. In 2005 and 2006, these figures were negative, whereas the industry
norms were positive. In 2008 and 2009, however, Acme Corporation had a much higher
return on equity than the average firm in its industry.
Next, we examine the liquidity ratios. The current ratio, 2.2, has been rising each
year through 2009, when it was 3.3. Having two times or more the amount of current
assets as current liabilities is a good target for most companies. Because the industry
norm for the current ratio was below the value Acme Corporation had each of these
years, Acme had a comparatively high liquidity position.
The quick ratio stayed near the industry norm throughout this period until it spiked to
2.2 in 2009. This means that when inventory is subtracted from total current assets, Acme
Corporation’s liquidity looked steady. Again, however, 2009’s value (2.2 for Acme versus
1.2 for the industry norm) suggests that management should watch liquidity in 2010.
Acme had a high debt load until 2008. The debt to total asset ratio was consistently
above 80 percent, whereas the industry norm for this ratio was 62 percent or less from
2005 to 2008. A high debt load magnifies the changes in the return on equity ratio values.
The times interest earned ratio shows that Acme Corporation barely covered its
interest expense with its operating income until 2009. The value of this ratio was slightly
more than 1, except for 2009, when it jumped to 4.2.
Now let’s look at the asset activity ratios. The average collection period has been
significantly lower for Acme than for the average firm in its industry. It appears that
Acme is doing a better than average job of collecting its accounts receivable.
The inventory turnover ratio was erratic over this fiveyear period. The fluctuations
suggest that Acme did not match its inventory to its demand for products. The numbers
suggest that Acme’s managers should have studied its inventory control policies to
look for ways to match demand and inventory more closely. There was a big increase
in 2009. More about this in Chapter 19.
The total asset turnover ratio was consistently just above the industry norm. This
helped the return on assets ratio during the years when net income was positive, as
described earlier. Chapter 5 113 Analysis of Financial Statements Table 53 FiveYear Ratio Analysis for Acme Corporation
Ratios 2005 2006 2007 2008 2009 Acme 36.2% 38.9% 42.8% 58.9% 66.7% Ind 55.7% 58.9% 62.2% 66.0% 68.0% Acme 14.3% 16.5% 18.6% 28.9% 48.0% Ind 34.2% 35.1% 37.5% 40.0% 42.0% Acme –8.5% –5.8% 3.4% 7.8% 21.2% Profitability Ratios
Gross Profit Margin
(Gross Profit ÷ Sales)
Operating Profit Margin
(EBIT ÷ Sales)
Net Profit Margin
(Net Income ÷ Sales)
Return on Assets (ROA)
(Net Income ÷ Total Assets)
Return on Equity (ROE)
(Net Income ÷ Common Equity) Ind 4.3% 6.4% 10.2% 11.5% 13.4% Acme –1.8% –2.2% 2.6% 4.1% 6.4% Ind 1.2% 1.8% 2.2% 2.5% 2.1% –14.6% –7.5% 2.8% 8.3% 12.2% 3.9% 4.4% 5.1% 5.6% 7.8% Acme 2.2 2.2 2.3 2.6 3.3 Ind 2.0 2.0 2.1 2.2 2.2 Acme 1.0 1.2 1.3 1.4 2.2 Ind 1.1 1.0 1.1 1.1 1.2 Acme 81.0% 81.0% 82.0% 55.1% 48.0% Ind 62.0% 59.0% 57.0% 58.0% 60.0% Acme 1.1 1.2 1.2 1.4 4.2 Ind 3.7 3.8 4.0 4.2 4.3 Acme 33.8 31.5 30.1 28.4 24.3 Ind 40.2 39.8 38.4 37.3 40.0 0.4 0.5 0.8 0.5 1.5 Acme
Ind Liquidity Ratios
Current Ratio
(Current Assets ÷ Current Liabilities)
Quick Ratio
(Current Assets Less Inventor y ÷ Current Liabilities)
Debt Management Ratios
Debt to Total Assets
(Total Debt ÷ Total Assets)
Times Interest Earned
(EBIT ÷ Interest Expense)
Asset Activity Ratios
Average Collection Period (days)
(Accounts Receivable ÷ Average Daily Credit Sales)
Inventor y Turnover (on sales) Acme (Sales ÷ Inventor y) Ind 0.6 0.7 0.7 0.7 0.7 Total Asset Turnover Acme 0.3 0.2 0.2 0.2 0.3 (Sales ÷ Total Assets) Ind 0.2 0.2 0.1 0.2 0.2 Acme — — 80.0 36.0 25.0 Ind Market Value Ratios
PE Ratio
(Market Price per Share ÷ EPS)
Market to Book Ratio
(Market Price per Share ÷ Book Value per Share) 15.0 17.0 19.0 15.0 16.0 Acme 1.3 1.6 1.8 2.0 2.3 Ind 2.1 2.2 1.9 2.0 2.0 114 Part II Essential Concepts in Finance Finally, we turn to the market value ratios. Acme had no meaningful P/E ratios
for 2005 and 2006 because net income and, therefore, EPS, were negative. The P/E
ratio of 80 in 2007 shows investors had high expectations about Acme’s future growth,
but these expectations moderated in the next two years as the company matured. The
market to book value ratio shows an upward trend over the fiveyear period showing
that investors increasingly valued Acme’s future earnings potential above the company’s
asset liquidation value.
We have just finished a complete ratio analysis of Acme Corporation, including
examinations of the company’s profitability, liquidity, debt management, asset activity,
and market value ratios. To conduct the analysis, we combined trend and industry analysis
so we could see how Acme performed over time and how it performed relative to its
industry. Managers inside the company can use the results of the analysis to support
proposed changes in operations or organization; and creditors and investors outside the
company can use the results to support decisions about lending money to the company
or buying its stock. Locating Information about Financial Ratios
Ratio analysis involves a fair amount of research. Before analysts can calculate all
the ratios, they must locate the underlying, raw financial data. Analysts can gather
information about publicly traded corporations at most libraries, on CDROM databases,
and on the Internet.
A number of organizations publish financial data about companies and industries.
Many publications contain ratios that are already calculated. Table 54 contains a list
of publications that financial analysts find useful when they are researching companies
and industries. Many of them are available at local libraries. What’s Next
In this chapter we learned how to calculate and apply financial ratios to analyze the
financial condition of the firm. In Chapter 6 we will see how to use analyses to forecast
and plan for the company’s future. Summary
1. Explain how financial ratio analysis helps assess the health of a company.
Just as doctors assess a patient’s health, financial analysts assess the financial health of
a firm. One of the most powerful assessment tools is financial ratio analysis. Financial
ratios are comparative measures that allow analysts to interpret raw accounting data
and identify strengths and weaknesses of the firm.
2. Compute profitability, liquidity, debt, asset activity, and market value ratios.
Profitability, liquidity, debt, asset activity, and market value ratios show different aspects
of a firm’s financial performance. Profitability, liquidity, debt, and asset activity ratios
use information from a firm’s income statement or balance sheet to compute the ratios.
Market value ratios use market and financial statement information. Chapter 5 Analysis of Financial Statements 115 Table 54 Sources of Financial Information
Business news, articles,
market data, stock, bond,
mutual fund price quotes Newspapers The Wall Street Journal, Barron’s, USA Today Business news, articles Magazines Forbes, Fortune, Business Week, Money Magazine Data on the economy,
industries; many financial
statistics (interest rates,
inflation, etc.) Bound publications US Industrial Outlook, Standard & Poor’s Statistical Surveys,
Standard & Poor’s Industry Surveys, Federal Reserve Bulletin,
World Almanac, Statistical Abstract of the United States, Business
Conditions Digest (contains leading, lagging, and coincident
indicators of the economy), Economic Report of the President Summary data about
industries, companies; advice
on industries, stocks; analysis
and forecasts Investment advisory
publications ValueLine Investment Survey (each company report appears on one
page), Standard & Poor’s Outlook Data on companies and
industries Computer databases Compustat PC Plus CDROM, Value Screen Company performance:
corporate financial data Bound publications Annual reports from the company (can often be obtained by phone
from the company), Standard & Poor’s Stock Reports (versions
for the NYSE, AMEX, and OTC markets), Standard & Poor’s
Corporation Records (contains indepth reports about companies,
including financial statement data), Moody’s Handbook of Common
Stocks (similar to the S&P Stock Reports), Moody’s Industrial
Manual, Moody’s Bank & Finance Manual, Moody’s OTC Manual,
Moody’s Public Utility Manual, Moody’s Transportation Manual,
Moody’s International Manual (all these Moody’s manuals contain
indepth reports on companies) Information about bonds Bound publications Moody’s Bond Record, Moody’s Bond Survey Information about mutual
funds Variety of business and
financial news and
information (some require
paid subscriptions) Morningstar Mutual Funds (similar to ValueLine but for mutual
funds), Weisenberger’s Management Results, Weisenberger’s
Current Performance & Dividend Record (similar to Moody’s
manuals but covers mutual funds)
Web http://www.bloomberg.com, http://www.compustat.com, http://
www.valueline.com, http://www.morningstar.com, http://public.
wsj.com/home.html, http://money.cnn.com, http://yahoo.com/
Business_and_Economy/Finance_and_Investment, http://www.sec.
gov/edgar.shtml, http://www.quicken.com, http://www.wsrn.com Profitability ratios measure how the firm’s returns compare with its sales, asset
investments, and equity. Liquidity ratios measure the ability of a firm to meet its
shortterm obligations. Debt ratios measure the firm’s debt financing and its ability
to pay off its debt. Asset activity ratios measure how efficiently a firm uses its assets.
Finally, market value ratios measure the market’s perception about the future earning
power of a business.
The Du Pont system analyzes the sources of ROA and ROE. Two versions of the
Du Pont equation were covered in this chapter. The first analyzes the contributions of
net profit margin and total asset turnover to ROA. The second version analyzes how the
influences of net profit margin, total asset turnover, and leverage affect ROE. 116 Part II Essential Concepts in Finance 3. Compare financial information over time and among companies.
Trend analysis compares past and present financial ratios to see how a firm has performed
over time. Industry analysis compares a firm’s ratios with the ratios of companies in
the same industry. Summary analysis, one of the most useful financial analysis tools,
combines trend and industry analysis to measure how a company performed over time
in the context of the industry.
4. Locate ratio value data for specific companies and industries.
A number of organizations publish financial data about companies and industries.
Many publications contain ratios that are already calculated. Table 54 contains a list
of publications that financial analysts find useful when they are researching companies
and industries. Equations Introduced in This Chapter
Profitability Ratios:
Gross Profit Margin =
Operating Profit Margin = Gross Profit
Sales
EBIT
Sales Net Profit Margin = Net Income
Sales Return on Assets = Net Income
Total Assets Return on Equity = Net Income
Common Stockholders Equity Liquidity Ratios:
Current Ratio =
Quick Ratio = Current Assets
Current Liabilities
Current Assets Less Inventory
Current Liabilities Debt Ratios:
Debt to Total Assets =
Times Interest Earned = Total Debt
Total Assets
EBIT
Interest Expense Chapter 5 Analysis of Financial Statements Asset Activity Ratios:
Average Collection Period =
Inventory Turnover =
Total Asset Turnover =
= Accounts Receivable
Average Daily Credit Sales
$1,
Sales000, 000
($15, 000, 000 / 365)
Inventory
$1, 000, 000
Sales
= 24.3 days
$41,Assets
Total 096 Market Value Ratios:
P / E Ratio = Market Price per Share
Earnings per Share Market to Book Value Ratio = Market Price per Share
Book Value per Share Economic Value Added (EVA) and Market Value Added (MVA):
EVA = EBIT(1 – TR) – (IC × Ka)
MVA = market value of debt plus equity –
book value debt plus equity Equation 51. The Du Pont Formula:
Return on Assets = Net Profit Margin × Total Asset Turnover
Sales
Net Income
Net Income
=
×
Total Assets
Total Assets
Sales Equation 52. The Modified Du Pont Formula:
Return on Equity = Net Profit Margin Total Asset Turnover Equity Multiplier Net Income
Net Income
Sales
Total Assets
=
×
×
Common Stockholders’ Equity
Sales
Total Assets
Common Stockholders’ Equity 117 118 Part II Essential Concepts in Finance SelfTest
ST1 De Marco Corporation has total assets of $5
million and an asset turnover ratio of 4. If net
income is $2 million, what is the value of the
net profit margin? ST2 Francisco Company has current assets of
$50,000. Total assets are $200,000; and longterm liabilities and common stock collectively
total $180,000. What is the value of the current
ratio? ST3 Mitra Company has a quick ratio value of 1.5.
It has total current assets of $100,000 and
total current liabilities of $25,000. If sales are
$200,000, what is the value of the inventory
turnover ratio? ST6 Yates Corporation has total assets of $500,000.
Its equity is $200,000. What is the company’s
debt to total asset ratio? ST7 Pendell Company has total sales of $4 million.
Onefourth of these are credit sales. The
amount of accounts receivable is $100,000.
What is the average collection period for the
company? Use a 365day year. If onehalf the current assets in ST2 consist of
inventory, what is the value of the quick ratio? ST4 ST5 Sheth Corporation has a return on assets ratio
of 6 percent. If the debt to total assets ratio is
.5, what is the firm’s return on equity? Review Questions
1. What is a financial ratio?
2. Why do analysts calculate financial ratios?
3. Which ratios would a banker be most interested in
when considering whether to approve an application for a shortterm business loan? Explain.
4. In which ratios would a potential longterm bond
investor be most interested? Explain. 5. Under what circumstances would market to book
value ratios be misleading? Explain.
6. Why would an analyst use the Modified Du Pont
system to calculate ROE when ROE may be calculated more simply? Explain.
7. Why are trend analysis and industry comparison
important to financial ratio analysis? Build Your Communication Skills
CS1 Research a publicly traded company that has
a presence in your community. Assess the
financial health of this company in the areas of
profitability, liquidity, debt, and asset activity.
Write a report of your findings. Include in
your report a discussion of the strengths and
weaknesses of the company, key trends, and
how the company’s ratios compare with other
companies in its industry. CS2 You have just been given a job as a loan
officer. It is your job to evaluate business loan
applications. Your boss would like you to
prepare a new set of guidelines to be used by
the bank to evaluate loan requests, leading to
the approval or denial decision.
Prepare a loan application packet. Include
the specific quantitative and qualitative
information you would want an applicant for
a loan to provide to you. Explain in a brief
report, oral or written, how you would use the
requested information to decide whether a loan
should be approved. Chapter 5 119 Analysis of Financial Statements Problems
51. Profitability
Ratios The 2009 income statement for TeleTech is shown here:
Net Sales $35,000,000 Cost of Goods Sold 15,000,000 Gross Profit 20,000,000 Selling and Admin. Expenses
Depreciation
Operating Income (EBIT)
Interest Expense
Income before Taxes (EBT) 1,000,000
3,000,000
16,000,000
2,500,000
13,500,000 Taxes (40%) 5,400,000 Net Income 8,100,000 Calculate the following:
a. Gross profit margin
b. Operating profit margin
c. Net profit margin
52. Rally’s has notes payable of $500, longterm debt of $1,900, inventory of
$900, total current assets of $5,000, accounts payable of $850, and accrued
expenses of $600. What is Rally’s current ratio? What is its quick ratio? Liquidity Ratios 53. XYZ Corporation has annual credit sales equal to $5 million, and its
accounts receivable account is $500,000. Calculate the company’s average
collection period. Asset Activity
Ratios 54. In 2009, TeleTech had sales of $35 million. Its current assets are $15 million,
$12 million is in cash, accounts receivable are $600,000, and net fixed assets
are $20 million. What is TeleTech’s inventory turnover? What is its total
asset turnover? Asset Activity
Ratios 55. The following data apply to Ramchander Corporation: Market Value
Ratios Total Common Stock Equity at YearEnd 2009
Number of Common Shares Outstanding
Market Price per Share Calculate the following:
a. Book value per share
b. Market to book value ratio $4,500,000
650,000
$25 120 Part II Essential Concepts in Finance Problems 5–6 to 5–11 refer to the consolidated income statement and consolidated
balance sheet of Pinewood Company and Subsidiaries that follow.
Pinewood Company and Subsidiaries
Income Statement for 2009 (000 dollars)
Sales $ 94,001 Cost of Goods Sold 46,623 Gross Profit 47,378 Selling and Administrative Expenses 28,685 Depreciation and R&D Expense (both tax deductible) 5,752 EBIT or Operating Income 12,941 Interest Expense 48 Interest Income 427 Earning Before Taxes (EBT) 13,320 Income Taxes 4,700 Net Income (NI) 8,620 Earnings per Share 1.72 Pinewood Company and Subsidiaries
Balance Sheet as of End of 2009 (000 dollars)
Assets:
Cash
Marketable Securities
Accounts Receivable (gross)
Less: Allowance for Bad Debts $ 5,534
952
14,956
211 Accounts Receivable (net) 14,745 Inventory 10,733 Prepaid Expenses
Plant and Equipment (gross)
Less: Accumulated Depreciation
Plant and Equipment (net) 3,234
57,340
29,080
28,260 Land 1,010 LongTerm Investments 2,503 Total Assets 66,971 Liabilities:
Accounts Payable
Notes Payable 3,253
Accrued Expenses 6,821 Bonds Payable 2,389 Stockholders’ Equity:
Common Stock 8,549 Retained Earnings 45,959 Total Liabilities and Equity 66,971 Chapter 5 121 Analysis of Financial Statements 56. Calculate the following profitability ratios for 2009.
a. Gross profit margin
b. Operating profit margin
c. Net profit margin
d. Return on assets
e. Return on equity
Comment on net profit margin and return on assets ratios if the industry average
for these two ratios are 5 percent and 14 percent, respectively. Profitability
Ratios 57. Calculate the following liquidity ratios for the end of 2009.
a. Current ratio
b. Quick ratio
Comment on the company’s ability to pay off shortterm debts. Liquidity Ratios 58. Calculate the following debt ratios for the end of 2009.
a. Debt to total assets
b. Times interest earned
Would a banker agree to extend a loan to Pinewood? Explain. Debt Management
Ratios 59. Calculate the following asset activity ratios for the end of 2009.
a. Average collection period
b. Inventory turnover
c. Total asset turnover
Comment on Pinewood’s asset utilization. Asset Activity
Ratios 510. Construct and solve Pinewood’s Modified Du Pont equation for 2009. Use
the end of 2009 asset figures. Comment on the company’s sources of ROE. Modified
Du Pont Equation 511. a. Calculate the economic value added (EVA) for Pinewood,
assuming that the firm’s income tax rate is 35 percent, the
weighted average rate of return expected by the suppliers of the
firm’s capital is 10 percent, and the market price of the firm’s
stock is $15. There are 5 million shares outstanding.
b. Comment on your results. What does the EVA value that you calculated
indicate?
c. Calculate the market value added (MVA) for Pinewood.
d. Comment on your results. What does the MVA value that you calculated
indicate? EVA/MVA 122 Part II Essential Concepts in Finance
EVA/MVA 512. Refer to the following financial statements for the Eversharp Drilling
Company.
Eversharp Drilling Company
Income Statement
For the Year Ended Dec. 31, 2009
Net Sales $11,000 Operating Expenses 3,000 Operating Income (EBIT) 8,000 Balance Sheet
Dec. 31, 2009
Assets:
Total Assets $ 21,000 Liabilities and Equity:
LongTerm Debt $ 6,000 Total Common Equity $ 15,000 Total Liabilities and Equity $ 21,000 a. Calculate the EVA for Eversharp, assuming that the firm’s income tax
rate is 35 percent, the weighted average rate of return expected by the
suppliers of the firm’s capital is 12 percent, and the market price of the
firm’s stock is $9. There are 3,000 shares outstanding.
b. Comment on your results. What does the EVA value that you calculated
indicate?
c. Calculate the MVA for the Eversharp Corporation.
d. Comment on your results. What does the MVA value that you calculated
indicate?
EVA/MVA 513. Refer to the following financial statements for the T & J Corporation.
T & J Corporation
Income Statement
For the Year Ended Dec. 31, 2009
Net Sales $ 10,000 Cost of Goods Sold 3,000 Gross Profit 7,000 Depreciation 200 S&A Expenses 300 Operating Income (EBIT) 6,500 Interest Expense 584 Income before Taxes 5,916 Income Taxes (35%) 2,071 Net Income $ 3,845 Earnings per Share (3,000 shares) $ 1.28 Chapter 5 Analysis of Financial Statements 123 Balance Sheet
Dec. 31, 2009
Assets:
Cash $ 350 Marketable Securities 300 Accounts Receivable 400 Inventory 680 Prepaid Expenses 200 Total Current Assets 1,930 Fixed Assets, Gross 63,000 Less Accumulated Depreciation (42,000 ) Fixed Assets, Net
Total Assets 21,000
$ 22,930 Liabilities and Equity:
Accounts Payable
Notes Payable
Accrued Expenses $ 740
630
350 Total Current Liabilities 1,720 LongTerm Debt 6,000 Total Liabilities 7,720 Common Stock 3,000 Capital in Excess of Par 6,610 Retained Earnings 5,600 Total Common Equity
Total Liabilities and Equity 15,210
$ 22,930 The total invested capital of the firm is $33,630.
a. Calculate the EVA for T & J Corporation, assuming that the firm’s income
tax rate is 35 percent, the weighted average rate of return expected by the
suppliers of the firm’s capital is 12 percent, and the market price of the
firm’s stock is $9.
b. Comment on your results. What does the EVA value that you calculated
indicate?
c. Calculate the MVA for the T & J Corporation.
d. Comment on your results. What does the MVA value that you calculated
indicate?
514. The following financial data relate to ABC Textile Company’s business
in 2009.
Sales
Net Income
Total Assets
Debt to Total Assets Ratio $1,000,000
$80,000
$500,000
0.5 or 50% a. Construct and solve the Du Pont and Modified Du Pont equations
for ABC. Du Pont Equation 124 Part II Essential Concepts in Finance b. What would be the value of the ROE ratio if the debt to total asset ratio
were 70 percent?
c. What would be the value of the ROE ratio if the debt to total asset ratio
were 90 percent?
d. What would be the value of the ROE ratio if the debt to total asset ratio
were 10 percent?
Financial
Relationships 515. From the values of the different ratios that follow, calculate the missing
balance sheet items and complete the balance sheet.
Sales $100,000 Average Collection Period 55 days Inventory Turnover 15 Debt to Assets Ratio .4 or 40% Current Ratio 3 Total Asset Turnover 1.6 Fixed Asset Turnover 2.9 Assets
Cash Liabilities + Equity
$6,000 Accounts Payable $ 6,000 Accounts Receivable Notes Payable Inventory Accrued Expenses Prepaid Expenses Total Current Liabilities Total Current Assets Bonds Payable Fixed Assets Common Stock 600 16,000 Retained Earnings
Total Assets
Financial
Relationships 516. Total Liabilities + Equity Given the partial financial statement information from La Strada
Corporation, a circus equipment supplier, calculate the return on equity ratio.
Total Assets $10,000 Total Liabilities 6,000 Total Sales 5,000 Net Profit Margin
Liquidity Ratios 517. 10% What is the current ratio of Ah, Wilderness! Corporation, given the following
information from its end of 2009 balance sheet?
Current Assets $ 5,000 LongTerm Liabilities
Total Liabilities 518. 20,000 Total Equity
Du Pont Equation 18,000
30,000 Rocinante, Inc., manufactures windmills. What is Rocinante’s total asset
turnover if its return on assets is 12 percent and its net profit margin is
4 percent? Chapter 5 125 Analysis of Financial Statements Use the following information to answer questions 519 to 525.
In 2009, Iron Jay opened a small sporting goods retail store called Iron Jay’s Sports
Stuff (IJSS). It immediately became very popular, and growth was only limited by
the amount of capital Jay could generate through profits and loans. Jay’s financial
manager advised him to incorporate. His manager said that by selling stock, Jay
would have the necessary capital to expand his business at an accelerated pace.
Answer the following questions relating to Iron Jay’s Sports Stuff.
519. The management team at IJSS is looking toward the future. They want to
maintain a gross profit margin of 50 percent. If the estimate for net sales
in 2010 is $5 million, how much gross profit will be necessary in 2010 to
maintain this ratio? Profitability Ratios 520. Using the data in 519, if the management team estimated $200,000 in
selling and administration expenses and $50,000 in depreciation expenses
for 2010, with net sales of $5 million, what operating profit margin can
they expect? Profitability Ratios 521. What must net income be in 2010 if IJSS also wants to maintain a net profit
margin of 20 percent on net sales of $5 million? Profitability Ratios 522. What will IJSS’s return on assets be if its total assets at the end of 2010
are estimated to be $20 million? Net sales are $5 million, and the net profit
margin is 20 percent in that year. Modified
Du Pont Equation 523. IJSS management knows the astute owners of IJSS stock will sell their stock
if the return on stockholders’ equity investment (return on equity ratio) drops
below 10 percent. Total stockholders’ equity for the end of 2010 is estimated
to be $15 million. How much net income will IJSS need in 2010 to fulfill the
stockholders’ expectation of the return on equity ratio of 10 percent? Profitability Ratios 524. Of the $20 million in total assets estimated for the end of 2010, only
$2 million will be classified as noncurrent assets. If current liabilities are
$4 million, what will IJSS’s current ratio be? Liquidity Ratios 525. Inventory on the balance sheet for the end of 2010 is expected to be $3
million. With total assets of $20 million, noncurrent assets of $2 million, and
current liabilities of $4 million, what will be the value of IJSS’s quick ratio? Liquidity Ratios 526. Given $20 million in total assets, $14 million in total stockholders’ equity,
and a debt to total asset ratio of 30 percent for Folson Corporation, what will
be the debt to equity ratio? Debt Ratios 527. If total assets are $20 million, noncurrent assets are $2 million, inventory is
$3 million, and sales are $5 million for Toronto Brewing Company, what is
the inventory turnover ratio? Asset Activity
Ratios 126 Part II Essential Concepts in Finance Du Pont Equation 528. If the net profit margin of Dobie’s Dog Hotel is maintained at 20 percent and
total asset turnover ratio is .25, calculate return on assets. Du Pont Equation 529. The following data are from Saratoga Farms, Inc., 2009 financial statements.
Sales $2,000,000 Net Income 200,000 Total Assets 1,000,000 Debt to Total Asset Ratio 60% a. Construct and solve the Du Pont and Modified Du Pont equations for
Saratoga Farms.
b. What would be the impact on ROE if the debt to total asset ratio were
80 percent?
c. What would be the impact on ROE if the debt to total asset ratio were
20 percent?
Various Ratios 530. The following financial information is from two successful retail operations
in Niagara Falls. Rose and George Loomis own Notoriously Niagara, a
lavish jewelry store that caters to the “personal jetset” crowd. The other
store, Niagara’s Notions, is a big hit with the typical tourist. Polly and Ray
Cutler, the owners, specialize in inexpensive souvenirs such as postcards,
mugs, and Tshirts.
Notoriously Niagara
Sales
Net Income
Assets $ 500,000
100,000
5,000,000 Niagara’s Notions
Sales
Net Income
Assets $ 500,000
10,000
500,000 a. Calculate the net profit margin for each store.
b. Calculate the total asset turnover for each store.
c. Combine the preceding equations to calculate the return on assets for each
store.
d. Why would you expect Notoriously Niagara’s net profit margin to be
higher than Niagara’s Notions, considering both stores had annual sales of
$500,000 and the same figure for return on assets?
Various Ratios 531. Thunder Alley Corporation supplies parts for Indianapolistype race cars.
Current market price per share of Thunder Alley’s common stock is $40.
The latest annual report showed net income of $2,250,000 and total common
stock equity of $15 million. The report also listed 1,750,000 shares of
common stock outstanding. No common stock dividends are paid.
a. Calculate Thunder Alley’s earnings per share (EPS).
b. Calculate Thunder Alley’s price to earnings (P/E) ratio.
c. Calculate Thunder Alley’s book value per share.
d. What is Thunder Alley’s market to book ratio?
e. Based on this information, does the market believe that the future earning
power of Thunder Alley justifies a higher value than could be obtained by
liquidating the firm? Why or why not? Chapter 5 532. 127 Analysis of Financial Statements Carrie White, the new financial analyst of Golden Products, Inc., has been
given the task of reviewing the performance of her company over three
recent years against the following industry information (figures in $000): Year Net
Income Current
Assets Current
Liabilities Total
Assets Total
Liabilities Sales 2007 $400 $500 $530 $3,800 $2,600 $4,000 2008 425 520 510 3,900 2,500 4,500 2009 440 550 510 4,000 2,400 Industry
Comparisons 4,700 The industry averages are
NI/Sales Current Ratio Total Assets Turnover 9.42% 1.13 2.00 Should Carrie be critical of her company’s performance?
533. Johnny Hooker, another financial analyst of Golden Products, Inc., is
working with the same yearly figures shown in 532, but he is trying to
compare the performance trend using another set of industry averages:
The industry averages are
Fixed
Asset Turnover Return
on Assets Debt to
Assets Ratio Return
on Equity 1.33 11.00% 0.60 Industry
Comparisons 26% Should Johnny be appreciative of his company’s performance?
534. Vernon Pinkby, the financial analyst reporting to the chief financial officer
of Alufab Aluminum Company, is comparing the performance of the
company’s four separate divisions based on profit margin and return on
assets. The relevant figures follow (figures in $000):
Mining
Net Income $ 500 Smelting Rolling Extrusion $ 2,600 $ 7,000 $ 2,500 Sales 15,000 30,000 60,000 25,000 Total Assets 12,000 25,000 39,000 18,000 a.
b.
c.
d. Compare profit margin ratios of the four divisions.
Compare return on assets ratios of the four divisions.
Compute profit margin of the entire company.
Compute return on assets of the entire company. Probability Ratios 128 Part II Essential Concepts in Finance Challenge Problem 535. From the values of the different ratios given, calculate the missing balance
sheet and income statement items of National Glass Company.
Average Collection Period 48.67 days Inventory Turnover 9x Debt to Asset Ratio .4 or 40% Current Ratio 1.6250 Total Asset Turnover 1.5 Fixed Asset Turnover 2.647 Return on Equity 0.1933 or 19.33% Return on Assets 0.116 or 11.6% Operating Profit Margin 13.33% Gross Profit Margin 48.89% National Glass Company Income Statement
for 2009 (000 dollars)
Sales $45,000 Cost of Goods Sold
Gross Profit
Selling and Administrative Expenses
Depreciation Expense 3,000 Operating Income (EBIT)
Interest Expense
Earnings before Taxes (EBT)
Income Taxes (T = 40%) 2,320 Net Income (NI)
National Glass Company Balance Sheet
as of End 2009
Assets: $ Cash
Accounts Receivable (gross)
Inventory
Plant and Equipment (net)
Land 1,000 Liabilities:
Accounts Payable 2,000 Notes Payable
Accrued Expenses 3,000 Bonds Payable
Stockholders’ Equity:
Common Stock
Retained Earnings 4,000 Chapter 5 536. Analysis of Financial Statements Kingston Tools Company (KTC) manufactures various types of highquality
punching and deepdrawing press tools for kitchen appliance manufacturers.
Horner Smith, the finance manager of KTC, has submitted a justification to
support the application for a shortterm loan from the Queensville Interstate
Bank (QIB) to finance increased sales. The consolidated income statement
and balance sheet of KTC, submitted with the justification to QIB, follow.
Kingston Tools Company Income Statement
for 2009 and 2010 (000 dollars)
2009
Sales 2010 $40,909 $45,000 Cost of Goods Sold 20,909 23,000 Gross Profit 20,000 22,000 Selling and Administrative Expenses 11,818 13,000 Depreciation Expense 2,000 3,000 Operating Income (EBIT) 6,182 6,000 Interest Expense 400 412 Earnings before Taxes (EBT) 5,782 5,588 Income Taxes (@ 40%) 2,313 2,235 Net Income (NI) 3,469 3,353 758 733 Dividends Paid (@ 21.86%) Kingston Tools Company Balance Sheet
as of End of 2009 and 2010 (000 dollars)
2009 2010 $ 2,000 $ 1,800 Accounts Receivable (net) 6,000 7,600 Inventory 5,000 5,220 26,000 31,000 Assets:
Cash Plant and Equipment (gross) 10,000 13,000 16,000 18,000 1,000 1,000 Accounts Payable 2,000 2,600 Notes Payable 3,000 3,300 Accrued Expenses 3,000 3,100 Bonds Payable 4,000 4,000 Less: Accumulated Depreciation
Plant and Equipment (net)
Land
Liabilities: Stockholders’ Equity:
Common Stock
Retained Earnings 4,000 4,000 14,000 16,620 129
Comprehensive
Problem 130 Part II Essential Concepts in Finance You are the loan officer at QIB responsible for determining whether KTC’s business is
strong enough to be able to repay the loan. To do so, accomplish the following:
a. Calculate the following ratios for 2009 and 2010, compare with the industry
averages shown in parentheses, and indicate if the company is doing better
or worse than the industry and whether the performance is improving or
deteriorating in 2010 as compared to 2009.
(i) Gross profit margin (50 percent)
(ii) Operating profit margin (15 percent)
(iii) Net profit margin (8 percent)
(iv) Return on assets (10 percent)
(v) Return on equity (20 percent)
(vi) Current ratio (1.5)
(vii) Quick ratio (1.0)
(viii) Debt to total asset ratio (0.5)
(ix) Times interest earned (25)
(x) Average collection period (45 days)
(xi) Inventory turnover (8)
(xii) Total asset turnover (1.6)
b. Calculate the EVA and MVA for Kingston Tools, assuming that the firm’s
income tax rate is 40 percent, the weighted average rate of return expected
by the suppliers of the firm’s capital is 10 percent, and the market price of
the firm’s stock is $20. There are 1.2 million shares outstanding.
c. Discuss the financial strengths and weaknesses of KTC.
d. Determine the sources and uses of funds and prepare a statement of cash
flows for 2010.
e. Compare and comment on the financial condition as evident from the ratio
analysis and the cash flow statement.
f. Which ratios should you analyze more critically before recommending
granting of the loan and what is your recommendation? Chapter 5 537. Ratio Analysis Refer to the following financial statements of Super Dot Com, Inc.
Super Dot Com, Inc.
Income Statements
(In 000’s, except EPS)
2007 2008 2009 $2,100 Net Sales $ 3,051 $3,814 681 995 1,040 Cost of Goods Sold 1,419 2,056 2,774 Selling and Admin. Expenses 610 705 964 Operating Profit 809 1,351 1,810 Interest Expense 11 75 94 798 1,276 1,716 Gross Profit Income before Tax
Income Tax (T = 35%) 279 447 Net Income $ 519 $ Dividends Paid $ 601 829 $1,115 $ Increase in Retained Earnings
Common Shares Outstanding 0
519 0
829 $ 0
1,115 2,500 2,500 2,500 $ 0.21 EPS $ 0.33 $ 0.45 Super Dot Com, Inc.
Balance Sheets
(In 000’s) as of Dec. 31, Years Ended:
Assets:
Cash and Equivalents 2007 2008 2009 $ 224 $ 103 Accounts Receivable 381 409 564 Inventories 307 302 960 69 59 29 981 873 1,720 1,901 3,023 3,742 (81) (82 ) 1,820 2,941 3,396 58 101 200 $2,859 $3,915 $ 5,316 $ 210 $ 405 $ Other Current Assets
Total Current Assets
Prop. Plant, and Equip., Gross
Less Accum. Depr.
Prop. Plant, and Equip., Net
Other Assets
Total Assets $ 167 (346 ) Liabilities and Equity:
Accounts Payable
ShortTerm Debt
Total Current Liabilities
LongTerm Debt 551 35 39 72 245 444 623 17 45 152 Total Liabilities 262 489 775 Common Stock 2,062 2,062 2,062 Retained Earnings
Total Equity
Total Liabilities and Equity 131 Analysis of Financial Statements 535 1,364 2,479 2,597 3,426 4,541 $2,859 $3,915 $ 5,316 132 Part II Essential Concepts in Finance a. How long, on average, was Super Dot Com taking to collect on its receivable
accounts in 2009? (Assume all of the company’s sales were on credit.)
b. Was Super Dot Com more or less profitable in 2009 than in 2007? Justify
your answer by examining the net profit margin and return on assets ratios.
c. Was Super Dot Com more or less liquid at the end of 2009 than it was at the
end of 2007? Justify your answer using the current and quick ratios. Answers to SelfTest
ST1. Sales ÷ $5,000,000 = 4, therefore sales = $20,000,000
$2,000,000 net income ÷ $20,000,000 sales = .1 = 10% net profit margin ST2. Current liabilities = $200,000 total assets – $180,000 LTD & CS = $20,000
$50,000 current assets ÷ $20,000 current liabilities = 2.5 current ratio ST3. Current assets – inventory = $50,000 – (.5 × $50,000) = $25,000
$25,000 ÷ $20,000 current liabilities = 1.25 quick ratio ST4. Debt ÷ assets = .5, therefore equity ÷ assets = .5, therefore assets ÷ equity =
1 ÷ .5 = 2
ROE = ROA × (A/E)
= .06 × 2
= .12, or 12% ST5. ($100,000 current assets – inventory) ÷ $25,000 = 1.5 quick ratio, therefore
inventory = $62,500
$200,000 sales ÷ $62,500 inventory = 3.2 inventory turnover ratio ST6. Debt = $500,000 assets  $200,000 equity = $300,000
$300,000 debt ÷ $500,000 assets = .6 = 60% debt to total asset ratio ST7. Credit sales = $4,000,000 ÷ 4 = $1,000,000
Average collection period = accounts receivable ÷ average daily credit sales =
$100,000
Accounts receivable ÷ ($1,000,000 annual credit sales ÷ 365 days per year) =
36.5 days ...
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This note was uploaded on 11/17/2011 for the course BUS 330 taught by Professor Nugent during the Fall '08 term at SUNY Stony Brook.
 Fall '08
 Nugent

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