C2
GOALS
Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.
Understand who uses financial ratios, and how.
Use ratios to analyze a firm’s liquidity and activity.
ACROSS THE DISCIPLINES
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 firm’s financial statements 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 stockholders’ report and why; how the financial statements will be analyzed by those both inside and outside the firm to assess various aspects of perform-
Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.
Use ratios to analyze a firm’s profitability and its market value.
Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.
WHY THIS CHAPTER MATTERS TO
Youance; the caution that 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 firm’s decisions about levels of inventory, credit policies, and pricing decisions.
Operations: You need to understand how the costs of operations are reflected in the firm’s 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.
44
LEARNING
F
THE HOME
DEPOT, INC.
BUILDING STRONG
Fl
NANCIALST
he primary responsibility of the chief financial officer (CFO) is no longer just financial reporting. Today’s CFO—a key member of the executive team—is also involved in strategic planning and, at many companies, information management. Managing a company’s financial operations takes many different skills.
Home Depot (www.homedepot.com) is the world’s largest home-improvement retailer and the second largest retailer in the United States. Its CFO and Executive Vice President, Carol Tome, reports directly to Chief Executive Officer Robert L. Nardinelli. She works closely with him to guide the giant firm’s future growth. One of Tome’s objectives is to improve the company’s return on investment
(RQI), a measure of managements effectiveness in generating profits with its available assets. In early 2004, Home Depot’s ROI was 20.49 percent, compared to 20.34 percent for the home-improvement retail industry as a whole and 13.07 percent for the services sector in general.Activity ratios that measure how quickly accounts are converted into cash are another focus of CFOs. Particularly important to a retail chain are inventory turnover, receivables collection period, and accounts payable periods. "We’re looking for processing efficiencies," Tome says. Improved new-store productivity and lower preopening costs per store, together with attention to cost control, help boost margins. In the first quarter of 2004, Home Depot reported a year-over-year same-store sales increase of 7.7 percent, the highest in 5 years.
The company’s measures of debt also indicate that it enjoys a strong financial position. In mid-2004, only 7 percent of Home Depot’s total long-term financing was debt, a very low degree of indebtedness. This strength gives Home Depot more flexibility to pursue new projects and more opportunities to raise funds from banks.
With knowledge of the financial fitness of the company, a CFO can make recommendations
on the deployment of capital. Home Depot plans capital spending of $3.7 billion in 2004, including
$1 billion to support its modernization program. In addition, the company spent $3.6 billion to repurchase shares during 2002 and 2003. In this chapter, you will learn how to use financial ratios to analyze
a firm’s financial fitness as shown in its financial statements.
• Increased
same-store sales are often a bellwether of improving financial strength. What aretwo
methods of raising same-store sales? Does either, or both, actually help the company?46
PART ONE Introduction to Managerial Finance
2.1
The Stockholders’ ReportEvery 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 profession’s rule-setting body, the Financial Accounting Standards Board (FASB). The Sarbanes-Oxley Act of 2002, enacted in an effort to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that oversees auditors of public corporations. The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. The expectation is that it will instill confidence in investors with regard to the accuracy of the audited financial statements of public companies. For more about the PCAQB, see the In Practice box on the facing page.
Publicly owned corporations with more than $5 million in assets and 500 or more stockholders’ are required by the Securities and Exchange Commission (SEC)—the federal regulatory body that governs the sale and listing of securities—to provide their stockholders with an annual stockholders’ report. The stockholders’ report summarizes and documents the firm’s financial activities during the past year. ft begins with a letter to the stockholders from the firm’s president and/or chairman of the board.
The Letter to Stockholders
The letter to stockholders is the primary communication from management. It describes the events that are considered to have had the greatest effect 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 book’s Web site
(www.aw—bc.coni/gitmaii) will take you to some representative letters to stockholders.
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 stockholders’ equity, and (4) the statement of cash flows.2 The financial statements from the 2006 stockholders’ report of Bartlett Company, a manufacturer of metal fasteners, are presented and briefly discussed. Note that an abbreviated form of the statement of stockholders’ equity—the statement of retained earnings—is described in the following discussions.
CHAPTER 2 Financial Statements and Analysis
47Income Statement
The income statement provides a financial summary of the firm’s 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. 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 (see page 48) presents Bartlett Company’s income statements for the years ended December 31, 2006 and 2005. The 2006 statement begins with sales revenue—the total dollar amount of sales during the period—from 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, 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
48
PART ONE Introduction to Managerial Finance
Bartlett Company Income Statements ($000)
For the years ended
December 31
2006 2005
Sales revenue $3,074 $2,567
Less: Cost of goods sold 2,088 1,711
Gross profits
Earnings per share (EPS)c
$ 2.90 $ 1.81Dividend per share (DPS)d
$ 1.29 $ 0.75
lease 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 2006 results because the firm has certain special tax write-offs that do not show up
directly on its income statement.
~CaIculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding—76,262 in 2006 and 76,244 in 2005. Earnings per share in 2006:
$221,000÷76,262 = $2.90;in2005: $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 2006: $98,000 ± 76,262 = $1.29; in 2005:
$57,183 ± 76,244 = $0.75.
tax costs. (Operating profit is often called earnings before interest and taxes, or EBIT) Next, the financial cost—interest expense—is subtracted from operating profits to find net profits (or earnings) before taxes. After subtracting $93,000 in 2006 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 Company’s net profits after taxes for 2006 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 represent the number of dollars earned during the period on behalf of each outstanding
CHAPTER 2 Financial Statements and Analysis
49
share of common stock. In 2006, 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 2006 was $1.29.
Balance Sheet
The balance sheet presents a summary statement of the firm’s financial position at a given point in time. The statement balances the firm’s assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners). Bartlett Company’s balance sheets as of December 31 of 2006 and 2005 are presented in Table 2.2 (see page 50). 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 firm’s books for more than 1 year.
As is customary, the assets are listed from the most liquid—cash—down 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 firm.4 Net fixed assets represent the difference between gross fixed assets and accumulated depreciation—the 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
50
PART ONE Introduction to Managerial Finance
Bartlett Company Balance Sheets ($000)
December 31
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable $ 382
$ 270
am
2006, 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.hAnnual principal repayments on a portion of the firm’s total outstanding debt amount to $71,000.
~The annual preferred stock dividend would be $5 per share (5% x $100 par), or a total of $10,000
annually ($5 per share X 2,000 shares(.
CHAPTER 2 Financial Statements and Analysis
51
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 firm’s assets.
Bartlett Company’s balance sheets in Table 2.2 show that the firm’s total assets increased from $3,270,000 in 2005 to $3,597,000 in 2006. 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
The statement of retained earnings is an abbreviated form of the statement of stockholders’ equity. Unlike the statement of stockholders’ equity, which shows all equity account transactions that occurred during a given
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, 2006. 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 2006.
Statement of Cash Flows
The statement of cash flows is a summary of the cash flows over the period of concern. The statement provides insight into the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Bartlett Company’s statement of cash flows for the year ended December 31, 2006, is presented in Table 2.4 (see page 52). Further insight into this statement is included in the discussion of cash flow in Chapter 3.
Bartlett Company Statement of Retained Earnings ($000)
for the Year Ended December 31, 2006
Retained earnings balance (January 1, 2006) $1,012
Plus: Net profits after taxes (for 2006) 231
Less: Cash dividends (paid during 2006)
Preferred stock $10 Common stock 98
Total dividends paid 108
$1,135
Retained earnings balance (December 31, 2006)
52
PART ONE Introduction to Managerial Finance
Bartlett Company Statement of Cash Flows ($000)
for the Year Ended December 31, 2006
Cash Flow from Operating Activities
Net profits after taxes $231
Depreciation 239
Increase in accounts receivable
Cash provided by operating activities $500
Cash Flow from Investment Activities
Increase in gross fixed assets ($347)
Change in business interests 0
Cash provided by investment activities
Cash Flow from Financing Activities
Decrease in notes payable
($ 20)
~As is customary, parentheses are used to denote a negative number, which in this case is a cash outflow. 5Retained 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
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 firm’s share value. The In Practice box on the facing page discusses some common corporate accounting misdeeds, their potential impact on investors, and how SOX has helped to eliminate them.
Consolidating International Financial Statements
So far, we’ve discussed financial statements involving only one currency, the U.S. dollar. The issue of how to consolidate a company’s foreign and domestic financial statements has bedeviled the accounting profession for many years. The current policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which mandates that U.S.-based companies translate their foreign-currency-
CHAPTER 2 Financial Statements and Analysis
53denominated assets and liabilities into dollars, for consolidation with the parent company’s financial statements. This is done by using a technique called the current rate (translation) method, under which all of a U.S. parent company’s 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 parent’s equity investment was made (the historical rate). Retained earnings are adjusted to reflect each year’s operating profits or losses.
54 PART ONE
Introduction to Managerial Finance
I
REVIEW QUESTIONS2—1 What roles do GAAP, the FASB, and the PCAOB play in the financial reporting activities of public companies?
2—2 Describe the purpose of each of the four major financial statements.
2—3 Why are the notes to the financial statements important to professional securities analysts?
2—4 How is the current rate (translation) method used to consolidate a firm’s foreign and domestic financial statements?
2.2
Using Financial RatiosThe information contained in the four basic financial statements is of major significance to a variety of interested parties who regularly need to have relative measures of the company’s 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 firm’s performance. The basic inputs to ratio analysis are the firm~s income statement and balance sheet.
Interested Parties
Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors, and the firm’s own management. Both current and prospective shareholders are interested in the firm’s current and future level of risk and return, which directly affect share price. The firm’s 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 firm’s profitability; they want assurance that the business is healthy. Management, like stockholders, is concerned with all aspects of the firm’s 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 firm’s performance from period to period.
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 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.
CHAPTER 2 Financial Statements and Analysis
55
Comparison to industry averages is also popular. These figures can be found in the Almanac of Business and Industrial Financial Ratios, Dun & Bradstreet’s Industry Norms and Key Business Ratios, Business Month, FTC Quarterly Reports, RMA Annual Statement Studies, Value Line, and industry sources.5 A sample from one available source of industry averages is given in Table 2.5 (see page 56).
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 2007, Mary Boyle, the chief financial analyst at Caldwell Manufacturing, a producer of heat exchangers, gathered data on the firm’s financial performance during 2006, 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 Manufacturing’s calculated inventory turnover for 2006 and the industry average inventory turnover were as follows:
Inventory turnover, 2006
Caldwell Manufacturing 14.8
Industry average 9.7
Mary’s 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 firm’s ability to meet demand and resulted in lost sales. A ratio that initially appeared to reflect extremely efficient inventory management was actually the symptom of a
major problem.
U
Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to past performance, using ratios, enables analysts to assess the firm’s progress. Developing trends can be seen
by using multiyear comparisons. Any significant year-to-year changes may be symptomatic of a major problem.56
PART ONE Introduction to Managerial Finance
Industry Average Ratios (2003) for Selected Lines of Businessa
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 2003—2006. This ratio reflects the average amount of time (in days) it takes the firm to collect bills, and lower values of this ratio generally are preferred. The figure quickly discloses that (1) Bartlett’s effectiveness in collecting its receivables is poor in comparison to the industry, and (2) Bartlett’s 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:
1. Ratios that reveal large deviations from the norm merely indicate symptoms of a problem. Additional analysis is typically needed to isolate the causes of the problem. The fundamental point is this: Ratio analysis 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
CHAPTER 2 Financial Statements and Analysis
57
FIGURE 2.1
used can reasonable judgments be made. However, if an analysis
is concerned only with certain specific aspects of a firm’s financial position, one or two ratios may suffice.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 seasonally 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 firm’s 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 firm’s true financial condition.
5. The financial data being compared should have been developed in the same way. The use of differing accounting treatments—especially relative to inventory and depreciation—can distort the results of ratio comparisons, regardless of whether cross-sectional or time-series analysis is used.
6. Results can he 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 when comparing 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.
58
PART ONE Introduction to Managerial Finance
As a rule, the inputs necessary for an effective financial analysis include, at a minimum, the income statement and the balance sheet. We will use the 2006 and 2005 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.
I
REVIEW QUESTIONS2—5
With regard to financial ratio analysis, how do the viewpoints held by the firm’s present and prospective shareholders, creditors, and management differ?2—6 What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking?
2—7 What types of deviations from the norm should the analyst pay primary attention to when performing cross-sectional ratio analysis? Why?
2—8 Why is it preferable to compare ratios calculated using financial statements that are dated at the same point in time during the year?
2.3
Liquidity RatiosThe 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 firm’s overall financial position—the ease with which
it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios can provide early signs of cash flow problems and impending business failure. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.
Current Ratio
The current ratio, one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-term obligations. It is expressed as follows:
Current asscts
Current
ratioCurrent
liabilitiesThe current ratio for Bartlett Company in 2006 is
$1,223,000
_________ =
1.97$620,000
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 value’s 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
CHAPTER 2 Financial Statements and Analysis
59
be unacceptable for a manufacturing firm. The more predictable a firm’s 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
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:6The quick ratio for Bartlett Company in 2006 is
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 firm’s inventory cannot be easily converted into cash. If inventory is liquid, the current ratio is a preferred measure of overall liquidity.
REVIEW QUESTION
2—9 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 RatiosActivity ratios measure the speed with which various accounts are converted into sales or cash—inflows or outflows. With regard to current accounts, measures of liquidity are generally inadequate because differences in the composition of a firm’s 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
60
PART ONE Introduction to Managerial Finance
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 commonly measures the activity, or liquidity, of a firm’s inventory. It is calculated as follows:
Cost of goods sold
Applying this relationship to Bartlett Company in 2006 yields
$2,088,000
_Inventory turnover = — 7.2
$289,000
The resulting turnover is meaningful only when
it is compared with that of other firms in the same industry or to the firm’s past inventory turnover. An 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 365—the assumed number of days in a year.8 For Bartlett Company, the average age of inventory in 2006 is 50.7 days (365 ÷ 7.2). This value can also be viewed as the average number of days’ sales in inventory.
Average Collection Period
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:Acconnts receivable
Average collection period
Average sales per day
Accounts receivable
Annual sales
365
61
CHAPTER 2 Financial Statements and Analysis
The average collection period for Bartlett Company in 2006 is
$503,000
_ $503,000 — 59.7 days$3,074,000 — $8,422
365
On the average, it takes the firm 59.7 days to collect an account receivable.
The average collection period is meaningful only in relation to the firm’s credit terms. If Bartlett Company extends 30-day credit terms to customers, an average collection period of 59.7 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 59.7-day average collection period would be quite acceptable. Clearly, additional information is needed to evaluate the effectiveness of the firm’s credit and collection policies.
Average Payment Period
The average payment period, or average age of accounts payable, is calculated in the same manner as the average collection period:
Accounts payable
Average
payment Period Average purchases per day
Accounts payable
Annual purchases
365
The difficulty in calculating this ratio stems from the need to find annual purchases,li 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 Company’s purchases equaled 70 percent of its cost of goods sold in 2006, its average payment period is
$382,000 $382,000
_______________ ________ = 95.4 days
0.70 \
$2,088,000 $4,004This figure is meaningful only in relation to the average credit terms extended to the firm. If Bartlett Company’s 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 firm’s bill-paying patterns.
62
PART ONE Introduction to Managerial Finance
Total Asset Turnover
The total asset turnover indicates the efficiency with which the firm uses its assets to generate sales. Total asset turnover is calculated as follows:
SaIe~
The value of Bartlett Company’s total asset turnover in 2006 is
$3,074,000
=
0.85$3,597,000
This means the company turns over its assets 0.85 times per year.
Generally, the higher a firm’s 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 firm’s operations have been financially efficient.
REVIEW QUESTION
2—10 To assess the firm’s average collection period and average payment period ratios, what additional information is needed, and why?
• 2.5
Debt RatiosThe debt position of a firm indicates the amount of other people’s 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 contractual payments over the long run. The more debt a firm has, the greater its risk of being unable to meet its contractual debt payments and becoming bankrupt. Because creditors’ claims must be satisfied before the earnings can be distributed to shareholders, current and prospective shareholders pay close attention to the firm’s ability to repay debts. Lenders are also concerned about the firm’s 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 assets—is 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
CHAPTER 2 Financial Statements and Analysis
Financial Statements Associated with Patty’s Alternatives
No-debt plan
Debt plan
Balance Sheets
Current assets $20,000 $20,000
Fixed assets 30,000 30,000
Total assets $50,000 $50,000
Debt (12% interest)
Income Statements
Sales
Less: Costs and operating expenses
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes (rate 40%)
(2) Net profits after taxes
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 Patty’s $50,000 investment. The debt plan results in $5,400 of after-tax profits, which represent a 21.6% rate of return on Patty’s 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. U
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 firm’s risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial debt ratios to assess externally a firm’s 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 firm’s ability to make the payments required on a scheduled basis over the life of a debt.i2 The firm’s ability to pay certain fixed charges is measured using coverage ratios. Typically, higher coverage ratios are preferred, but too high a ratio (above
63
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PART ONE Introduction to Managerial Finance
industry norms) may result in unnecessarily low risk and return. In general, the lower the firm’s 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 fixed-payment coverage ratio.13
Debt Ratio
The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this ratio, the greater the amount of other people’s money being used to generate profits. The ratio is calculated as follows:
Jotal liabilities
Debt ratio =
Total assets
The debt ratio for Bartlett Company in 2006 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 firm’s degree of indebtedness and the more financial leverage it has.
Times Interest Earned Ratio
The times interest earned ratio, sometimes called the interest coverage ratio, measures the firm’s 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 earne(l 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 2006 value:
Times interest earned ratio
= $418,000 =$93,000
The times interest earned ratio for Bartlett Company seems acceptable. A value of at least 3.0—and preferably closer to 5.0—is often suggested. The firm’s earnings before interest and taxes could shrink by as much as 78 percent
L(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.CHAPTER 2 Financial Statements and Analysis
65
Fixed-Payment Coverage Ratio
The fixed-payment coverage ratio measures the firm’s ability to meet all fixed-payment obligations, such as loan interest and principal, lease payments, and preferred stock dividends.’4 As is true of the times interest earned ratio, the higher this value, the better. The formula for the fixed-payment coverage ratio is
Li xed
payment Earnings before interest and
taxes -in- lease paymentswhere Tis the corporate tax rate applicable to the firm’s income. The term 1/(1 — T) is included to adlust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-tax values of all other terms. Applying the formula to Bartlett Company’s 2006 data yields
Fixed-payment $418,000 + $35,000
coverage ratio $93,000 + $35,000 + {($71,000 + $10,000) X [1/(1 — 0.29)~} $453,000
—
=1.9 $242,000
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 firm’s ability to meet additional fixed-payment obligations without being driven into bankruptcy.
I
REVIEW QUESTIONS2—11
What is financial leverage?2—12 What ratio measures the firm’s degree of indebtedness? What ratios assess the firm’s ability to service debts?
2.6
Profitability RatiosThere are many measures of profitability. As a group, these measures enable the analyst to evaluate the firm’s 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.
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PART ONE Introduction to Managerial Finance
Common-Size Income Statements
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 2006 and 2005 for Bartlett Company are presented and evaluated in Table 2.7. These statements reveal that the firm’s cost of goods sold increased from 66.7 percent of sales in 2005 to 67.9 percent in 2006, resulting in a worsening gross profit margin. However, thanks to a decrease in total operating expenses, the firm’s net profit margin rose from 5.4 percent of sales in 2005 to 7.2 percent in 2006. The decrease in expenses more than corn-
Bartlett Company Common-Size Income Statements
For the years ended
December 31 Evaluationa
2006 2005 2005—2006
Less: Operating expenses
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
Total operating expense 18.5% 21.5% better
(2) Operating profit margin 13.6% 11.8% better
Less: Interest expense 3.0 3.5 better
Net profits before taxes 10.6% 8.3% better
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
(3) Net profit margin 7.2% 5.4% better
CHAPTER 2 Financial Statements and Analysis
67
pensated for the increase in the cost of goods sold. A decrease in the firm’s 2006 interest expense (3.0 percent of sales versus 3.5 percent in 2005) added to the increase in 2006 profits.
Gross Profit Margin
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:
Sa
csBartlett Company’s gross profit margin for 2006 is
$3,074,000
— $2,088,000 _ $986,000— =32.1%
$3,074,000 $3,074,000
This value is labeled (1) on the common-size income statement in Table 2.7.
Operating Profit Margin
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:
Bartlett Company’s operating profit margin for 2006 is
$418,000
________ =
13.6%$3,074,000
This value is labeled (2) on the common-size income statement in Table 2.7.
Net Profit Margin
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 firm’s net profit margin, the better. The net profit margin is calculated as follows:
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PART ONE Introduction to Managerial Finance
Bartlett Company’s net profit margin for 2006 is
$221,000
________ = 7.2%
$3,074,000
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 firm’s 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)
The firm’s 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 available
for common stockholdersEarnings per
share Number of shares (if common stock outstanding
Bartlett Company’s earnings per share in 2006 is
$221,000
________ =
$2.9076,262
This figure represents the dollar amount earned on behalf of each outstanding share of common stock. The dollar amount of cash actually distributed to each shareholder is the dividend per share (DPS), which, as noted in Bartlett Company’s income statement (Table 2.1), rose to $1.29 in 2006 from $0.75 in 2005. EPS is closely watched by the investing public and is considered an important indicator of corporate success.
Return on Total Assets (ROA)
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 firm’s return on total assets, the better. The return on total assets is calculated as follows:
Earnings available for common stockholders
Return
on total assets --__________________________________Total assets
Bartlett Company’s return on total assets in 2006 is
$221,000
_______ =
6.1%$3,597,000
This value indicates that the company earned 6.1 cents on each dollar of asset investment.
CHAPTER 2 Financial Statements and Analysis
69
Return on Common Equity (ROE)
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:
Rettirn on common equity Earnings available
for comrmm stockholdersCommon stock eq u i tx
This ratio for Bartlett Company in 2006 is
$221,000
________ =
12.6%$1,754,000
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 Company’s 2006 balance sheet in Table 2.2). The calculated ROE of 12.6 percent indicates that during 2006 Bartlett earned 12.6 cents on each dollar of common stock equity.
I
REVIEW QUESTIONS2—13 What three ratios of profitability are found on a common-size income statement?
2—14 What would explain a firm’s having a high gross profit margin and a low net profit margin?
2—15 Which measure of profitability is probably of greatest interest to the investing public? Why?
2.7
Market RatiosMarket ratios relate the firm’s 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 firm’s 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
The price/earnings (PIE) ratio is commonly used to assess the owners’ appraisal of share value.’6 The PIE ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings. The level of this ratio indicates the degree of
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PART ONE Introduction to Managerial Finance
confidence that investors have in the firm’s future performance. The higher the PIE ratio, the greater the investor confidence. The PIE ratio is calculated as follows:
lIflhTH’. (B 1K) ratio N larket price per share ot coliiliion st( )ck
ha ri~ ngs per sli are
If Bartlett Company’s common stock at the end of 2006 was selling at $32.25, using the EPS of $2.90, the PIE ratio at year-end 2006 is
$32.25
$2.90
= 11.1This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The PIE 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
The market/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It relates the market value of the firm’s shares to their book— strict accounting—value. To calculate the firm’s
M/B ratio, we first need to find the book value per share of common stock:l’~ ok
value per share ( oFlmloIl stock equitySubstituting the appropriate values for Bartlett Company from its 2006 balance sheet, we get
Book value per share
_ $1,754,000— __________ =
$23.00of common stock 76,262
The formula for the market/book ratio is
Market book (NI
fl) ratio N larket price per shari o1 corn 110)11 stock1k ~a
ne per share of com mon storkSubstituting Bartlett Company’s end of 2006 common stock price of $32.25 and its $23.00 book value per share of common stock (calculated above) into the
MIB ratio formula, we get$32.25
Market/book (M/B) ratio
= ______ = 1.40$23.00
This
MJB ratio means that investors are currently paying $1.40 for each $1.00 of book value of Bartlett Company’s stock.The stocks of firms that are expected to perform well—improve profits, increase their market share, or launch successful products—typically 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 MJB multiples. Clearly, Bartlett’s future prospects are being viewed favor-CHAPTER 2 Financial Statements and Analysis
71
ably by investors, who are willing to pay more than its book value for the firm’s shares. Like P/E ratios, NI/B ratios are typically assessed cross-sectionally, to get a feel for the firm’s risk and return compared to peer firms.
REVIEW QUESTION
2—16 How do the price/earnings (PIE) ratio and the market/book (MIB) ratio provide a feel for the firm’s risk and return?
2.8
A Complete Ratio AnalysisAnalysts frequently wish to take an overall look at the firm’s 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 firm’s 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 firm’s financial condition.
Summarizing All Ratios
We can use Bartlett Company’s ratios to perform a complete ratio analysis using both cross-sectional and time-series analysis approaches. The 2006 ratio values calculated earlier and the ratio values calculated for 2004 and 2005 for Bartlett Company, along with the industry average ratios for 2006, are summarized in Table 2.8 (see pages 72 and 73), which also shows the formula used to calculate each ratio. Using these data, we can discuss the five key aspects of Bartlett’s performance—liquidity, activity, debt, profitability, and market.
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 2006. The firm’s liquidity seems to be good.
Activity
Bartlett Company’s inventory appears to be in good shape. Its inventory management seems to have improved, and in 2006 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 firm’s credit standing. Although overall liquidity appears to be good, the management of receivables and payables should be examined. Bartlett’s total asset turnover reflects a decline in the efficiency of total asset utilization between 2004 and 2005. Although in 2006 it rose to a level considerably above the industry average, it appears that the pre-2005 level of efficiency has not yet been achieved.
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PART ONE Introduction to Managerial Finance74
PART ONE Introduction to Managerial FinanceDebt
Bartlett Company’s indebtedness increased over the 2004—2006 period and is currently above the industry average. Although this increase in the debt ratio could be cause for alarm, the firm’s ability to meet interest and fixed-payment obligations improved, from 2005 to 2006, to a level that outperforms the industry. The firm’s increased indebtedness in 2005 apparently caused a deterioration in its ability to pay debt adequately. However, Bartlett has evidently improved its income in 2006 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 2005 was an off year, the company’s improved ability to pay debts in 2006 compensates for its increased degree of indebtedness.
Profitability
Bartlett’s profitability relative to sales in 2006 was better than the average company in the industry, although it did not match the firm’s 2004 performance. Although the gross profit margin was better in 2005 and 2006 than in 2004, higher levels of operating and interest expenses in 2005 and 2006 appear to have caused the 2006 net profit margin to fall below that of 2004. However, Bartlett Company’s 2006 net profit margin is quite favorable when compared to the industry average.
The firm’s earnings per share, return on total assets, and return on common equity behaved much as its net profit margin did over the 2004—2006 period. Bartlett appears to have experienced either a sizable drop in sales between 2004 and 2005 or a rapid expansion in assets during that period. The exceptionally high 2006 level of return on common equity suggests that the firm is performing quite well. The firm’s above-average returns—net profit margin, EPS, ROA, and ROE—may be attributable to the fact that it is more risky than average. A look at market ratios is helpful in assessing risk.
Market
Investors have greater confidence in the firm in 2006 than in the prior two years, as reflected in the price/earnings (PIE) ratio of 11.1. Howevei this ratio is below the industry average. The PIE ratio suggests that the firm’s risk has declined but remains above that of the average firm in its industry. The firm’s market/book (NI/B) ratio has increased over the 2004—2006 period, and in 2006 it exceeds the industry average. This implies that investors are optimistic about the firm’s future performance. The PIE and
MIB ratios reflect the firm’s increased profitability over the 2004—2006 period: Investors expect to earn high future returns as compensation for the firm’s 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 2005—2006 period seems to reflect a phase of adjustment and recovery from the rapid growth in assets. Bartlett’s 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 2006.
CHAPTER 2 Financial Statements and Analysis
75
DuPont System of Analysis
The DuPont system of analysis is used to dissect the firm’s 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 (see page 76) depicts the basic DuPont system with Bartlett Company’s 2006 monetary and ratio values. The upper portion of the chart summarizes the income statement activities; the lower portion summarizes the balance sheet activities.
Dupont Formula
The DuPont system first brings together the net profit margin, which measures the firm’s 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):
= Net
profit margin 2< ]otal asset turnoverSubstituting the appropriate formulas into the equation and simplifying results in the formula given earlier,
t-Iarnings
available for Earnings available forCOlflfliOll stockholders
Sales common stockholders
When the 2006 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% x 0.85 = 6.1%This value is the same as that calculated directly in an earlier section (page 68). The DuPont formula enables the firm to break down its return into profit-on-sales 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.
Modified Dupont Formula
The second step in the DuPont system employs the modified DuPont formula. This formula relates the firm’s 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 (ELM), which is the ratio of total assets to common stock equity:
ROE
ROA x ELMSubstituting the appropriate formulas into the equation and simplifying results in the formula given earlier,
Earnings available for Earnings available for
common stockholders Total assets corn mon
stock holdersROE --~- __
xTotal assets Common stock equity Common stock equity
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PART ONE Introduction to Managerial Finance
FIGURE 2.2 Dupont System of Analysis
The DuPont system of analysis with application to Bartlett Company (2006)
CHAPTER 2 Financial Statements and Analysis
77
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 Company’s ROA of 6.1 percent, calculated earliei; and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the modified DuPont formula yields
ROE
= 6.1% x 2.06—12.6%The 12.6 percent ROE calculated by using the modified DuPont formula is the same as that calculated directly (page 69).
Applying the Dupont System
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-of-asset-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 value—the ROE—the financial analyst moves to the left, dissecting and analyzing the inputs to the formula to isolate the probable cause of the resulting above-average (or below-average) value.
For the sake of demonstration, let’s ignore all industry average data in Table 2.8 and assume that Bartlett’s ROE of 12.6 % is actually below the industry average. Moving to the left in Figure 2.2, we would examine the inputs to the ROE—the ROA and the ELM—relative to the industry averages. Let’s assume that the ELM 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 ROA—the 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 firm’s sales are consistent with the industry value, Bartlett’s total assets have grown significantly during the past year. Looking farther to the left, we would review the firm’s activity ratios for current assets. Let’s say that whereas the firm’s inventory turnover is in line with the industry average, its average collection period is well above the industry average.
We can readily trace the possible problem back to its cause: Bartlett’s 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 Bartlett’s total asset turnover driving down its ROA, which then drove down its ROE. By using the DuPont system of analysis to dissect Bartlett’s 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 better manage its credit operations.
REVIEW QUESTIONS2—17 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?
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PART ONE Introduction to Managerial Finance
2—18 Describe how you would use a large number of ratios to perform a complete ratio analysis of the firm.
2—19 What three areas of analysis are combined in the modified DuPont formula? Explain how the DuPont system of analysis is used to dissect the firm’s results and isolate their causes.
Summary
Financial managers review and analyze the firm’s financial statements periodically, both to uncover developing problems and to assess the firm’s progress toward achieving its goals. These actions are aimed at preserving and creating value for the firm’s 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 the contents of the stockholders’ report and the procedures for
consolidating international financial statements. The annual stockholders’ report, which publicly owned corporations must provide to stockholders, documents the firm’s financial activities of 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 stockholders’ equity (or its abbreviated form, the statement of retained earnings), and the statement of cash flows. Notes describing the technical aspects of the financial statements follow. Financial statements of companies that have operations whose cash flows are denominated in one or more foreign currencies must be translated into dollars in accordance with FASB Standard No. 52.
Understand who uses financial ratios, and how. Ratio analysis enables
stockholders and lenders and the firm’s managers to evaluate the firm s financial performance. It can be performed on a cross-sectional or a time-series basis. Benchmarking is a popular type of cross-sectional analysis. Key cautions for applying financial ratios are as follow: (1) Ratios with large deviations from the norm merely 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 statements 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 firm’s liquidity and activity. Liquidity, or the 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 cash—inflows or outflows. The activity of inventory can be measured by its turnover; that of accounts receivable by the
CHAPTER 2 Financial Statements and Analysis
79
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.
Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s 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 coverage ratios.
Use ratios to analyze a firm’s 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.
Use a summary of financial ratios and the DuPont system of analysis to
perform a complete ratio analysis. A summary of all ratios—liquidity, activity, debt, profitability, and market—can be used to perform a complete ratio analysis using cross-sectional and time-series analysis. The DuPont system of analysis is a diagnostic tool used to find the key areas responsible for the firm’s 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 financial leverage.
Self-Test Problems (Solutions in Appendix B)
ST2—1 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 average? Create a table similar to the one that follows and fill in the empty blocks.80
PART ONE Introduction to Managerial Finance
ST2—2 Balance sheet completion using ratios Complete the 2006 balance sheet for O’Keefe Industries using the information that follows it.
Assets
Total assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets Net fixed assets
O’Keefe Industries Balance Sheet
December 31, 2006
Liabilities and Stockholders’ Equity
$32,720
25,000
$
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
Total liabilities and stockholders’ equity
The following financial data for 2006 are also available:
(1) Sales totaled $1,800,000.
(2) The gross profit margin was 25%.
(3) Inventory turnover was 6.0.
(4) There are 365 days in the year.
(5) The average collection period was 40 days.
(6) The current ratio was 1.60.
(7)
The total asset turnover ratio was 1.20.(8) The debt ratio was 60%.
E2—1 You are a summer intern at the office of a local tax-preparer. To test your basic knowledge of financial statements, your manager, who graduated from your
alma mater 2 years ago, gives you the following list of accounts and asks you to prepare a simple income statement using those accounts.
Accounts ($000,000)
Depreciation 25
a. Arrange the accounts into a well-labeled income statement. Make sure you label and solve for gross profit, operating profit, and net profit before taxes.
b. Using a 35% tax rate, calculate taxes paid and net profit after taxes.
Warm-Up Exercises
CHAPTER 2 Financial Statements and Analysis
81
c. Assuming a dividend of $1.10 per share with 4.25 million shares outstanding, calculate EPS and additions to retained earnings.
E2—2 Explain why the income statement can also be called a "profit and loss statement." What exactly does the word "balance" mean in the title of the balance sheet? Why do we balance the two halves?
E2—3 Cooper Industries, Inc., began 2006 with retained earnings of $25.32 million. During the year it paid four quarterly dividends of $0.35 per share to 2.75 million common stockholders. Preferred stockholders, holding 500,000 shares, were paid two semiannual dividends of $0.75 per share. The firm had a net profit after taxes of $5.15 million. Prepare the statement of retained earnings for the year ended December 31, 2006.
E2—4 Bluestone Metals, Inc., is a metal fabrication firm which manufactures prefabricated metal parts for customers in a variety of industries. The firm’s motto is "If you need it, we can make it." The CEO of Bluestone recently held a board meeting during which he extolled the virtues of the corporation. The company, he stated confidently, had the capability to build any product and could do so using a lean manufacturing model. The firm would soon be profitable, claimed the CEO, because the company used state of the art technology to build a variety of products while keeping inventory levels low. As a business press reporter, you have calculated some ratios to analyze the financial health of the firm. Bluestone’s current ratios and quick ratios for the past six years are shown in the table below:
2001 2002 2003 2004 2005 2006
Current ratio 1.2 1.4 1.3 1.6 1.8 2.2
Quick ratio 1.1 1.3 1.2 0.8 0.6 0.4
What do you think of the CEO’s claim that the firm is lean and soon to be profitable? (Hint: Is there a possible warning sign in the relationship between the two ratios?)
E2—5 If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72, and an equity multiplier of 1.43, what is its ROE? What is the advantage to using the DuPont system to calculate ROE over the direct calculation of earnings available for common stockholders ÷ common stock equity?
Problems
P2—i Reviewing basic financial statements The income statement for the year ended December 31, 2006, the balance sheets for December 31, 2006 and 2005, and the statement of retained earnings for the year ended December 31, 2006, for Technica, Inc., are given on pages 82 and 83. Briefly discuss the form and informational content of each of these statements.
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PART ONE Introduction to Managerial Finance
Technica, Inc.
Income Statement
for the Year Ended December 31, 2006
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses General and administrative expenses
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)
Assets
Cash
Total assets
Marketable securities
Accounts receivable
Inventories
Total current assets
Land and buildings
Machinery and equipment
Furniture and fixtures
Other
Total gross fixed assets
Less: Accumulated depreciation Net fixed assets
Liabilities and Stockholders’ Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
Common stock equity (shares
outstanding: 19,500 in 2006
and 20,000 in 2005)
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
$600,000
CHAPTER 2 Financial Statements and Analysis
Technica, Inc.
Statement of Retained Earnings
for the Year Ended December 31, 2006
Retained earnings balance (January 1, 2006) $50,200
Plus: Net profits after taxes (for 2006) 42,900
Less: Cash dividends (paid during 2006) 20,000
Retained earnings balance (December 31, 2006) $73,100
P2—2 Financial statement account identification Mark each of the accounts listed in the following table as follows:
a. In column (1), indicate in which statement—income statement (IS) or balance sheet (BS)—the account belongs.
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
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
(1) (2)
Statement Type of account
83
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PART ONE Introduction to Managerial Finance
P2—3 Income statement preparation On December 31, 2006, Cathy Chen, a self-employed certified public accountant (CPA), completed her first full year in business. During the year, she billed $360,000 for her accounting services. She had
two employees: a bookkeeper and a clerical assistant. In addition to her monthly salary of $8,000, Ms. Chen paid annual salaries of $48,000 and $36,000 to the bookkeeper and the clerical assistant, respectively. Employment taxes and benefit costs for Ms. Chen and her employees totaled $34,600 for the year. Expenses for office supplies, including postage, totaled $10,400 for the year. In addition, Ms. Chen spent $17,000 during the year on tax-deductible travel and entertainment associated with client visits and new business development. Lease payments for the office space rented (a tax-deductible expense) were $2,700 per month. Depreciation expense on the office furniture and fixtures was $15,600 for the year. During the yeas Ms. Chen paid interest of $15,000 on the $120,000 borrowed to start the business. She paid an average tax rate of 30 percent during 2006.a. Prepare an income statement for Cathy Chen, CPA, for the year ended December 31, 2006.
b. Evaluate her 2006 financial performance.
P2—4 Calculation of EPS and retained earnings Philagem, Inc., ended 2006 with a 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 Philagem’s 2006 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?
P2—5 Balance sheet preparation Use the appropriate items from the following list to prepare in good form Owen Davis Company’s balance sheet at December 31,
2006.
Value ($000) at Value ($000) at
Accounts payable $ 220 Inventories $ 375
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85
P2—6 Impact of net income on a firm’s balance sheet Conrad Air, Inc., reported net income of $1,365,000 for the year ended December 31, 2006. Show the effect of these funds on the firm’s balance sheet for the previous year (below) in each of the scenarios following the balance sheet.
Assets
Total assets
Cash
Marketable securities
Accounts receivable
Inventories Current assets
Equipment
Buildings
Fixed assets
Conrad Air, Inc.
Balance Sheet
as of December 31, 2006
Liabilities and Stockholders’ Equity
$
120,00035,000
45,000
130,000
$
330,000$2,970,000
1,600,000
$4,570,000
$4,900,000
Accounts payable Short-term notes
Current liabilities Long-term debt
Total liabilities
Common stock
Retained earnings
Stockholders’ equity
Total liabilities and equity
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.
P2—7 Initial sale price of common stock Beck Corporation has one issue of preferred stock and one issue of common stock outstanding. Given Beck’s 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 $ 125
P2—8 Statement of retained earnings Hayes Enterprises began 2006 with a retained earnings balance of $928,000. During 2006, the firm earned $377,000 after taxes. From this amount, preferred stockholders were paid $47,000 in dividends. At year-end 2006, the firm’s retained earnings totaled $1,048,000. The firm had 140,000 shares of common stock outstanding during 2006.
$
70,00055,000
$
125,000$2,700,000
$2,825,000
$
500,0001,575,000
$2,075,000
$4,900,000
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PART ONE Introduction to Managerial Finance
a. Prepare a statement of retained earnings for the year ended December 31, 2006, for Hayes Enterprises. (Note: Be sure to calculate and include the
amount of cash dividends paid in 2006.)
b. Calculate the firm’s 2006 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock during 2006?
P2—9 Changes in stockholders’ equity Listed are the equity sections of balance sheets for years 2005 and 2006 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 2005 2006
Common stock ($1.00 par)
Authorized—5,000,000 shares
Outstanding—1,500,000 shares 2006 $1,500,000
— 500,000 shares 2005 $ 500,000
Paid-in capital in excess of par 500,000 4,500,000
Retained earnings 1,000,000 1,500,000
Total stockholders’ equity $2,000,000 $7,500,000
The company paid total dividends of $200,000 during fiscal 2006.
a. What was Mountain Air’s net income for fiscal 2006?
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 2006 sell?
d. At what price per share did Mountain Air’s original 500,000 shares sell?
P2—10 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now invested, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed below.
Island Burger Fink Roland
Ratio Electric Utility Heaven Software Motors
Current ratio 1.10 1.3 6.8 4.5
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.
CHAPTER 2 Financial Statements and Analysis
87
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 wouldn’t investors invest all of their money in software companies instead of in less profitable companies? (Focus on risk and return.)
P2—li Liquidity management Bauman Company’s total current assets, total current liabilities, and inventory for each of the past 4 years follow:
Item 2003 2004 2005 2006
Total current assets $16,950 $21,900 $22,500 $27,000
a. Calculate the firm’s current and quick ratios for each year. Compare the resulting time series for these measures of liquidity.
b. Comment on the firm’s liquidity over the 2003—2006 period.
c. If you were told that Bauman Company’s inventory turnover for each year in the 2003—2006 period and the industry averages were as follows, would this information support or conflict with your evaluation in part b? Why?
Inventory turnover 2003 2004 2005 2006
Bauman Company 6.3 6.8 7.0 6.4
P2—12 Inventory management Wilkins Manufacturing has annual sales of $4 million and a gross profit margin of 40%. Its end-of-quarter inventories are
Quarter Inventory
1
$ 400,000
a. Find the average quarterly inventory and use it to calculate the firm’s 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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PART ONE Introduction to Managerial Finance
P2—13 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 S 3,875
a. Use the year-end total to evaluate the firm’s collection system.
b. If
70% of the firm’s sales occur between July and December, would this affect the validity of your conclusion in part a? Explain.P2—14 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 company’s short-term activity ratios. Your calculations and appropriate industry norms are listed.
Ratio Bluegrass Industry norm
Current ratio 4.5 4.0
a. What recommendations relative to the amount and the handling of inventory could you make to the new owners?
b. What recommendations relative to the amount and the handling of accounts receivable could you make to the new owners?
c. What recommendations relative to the amount and the 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?
P2—15 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,000 loan, to assess the firm’s financial leverage and financial risk. On the basis of the debt ratios for Creek, along with the industry averages and Creek’s recent financial statements (see the facing page), evaluate and recommend appropriate action on the loan request.
CHAPTER 2 Financial Statements and Analysis
89
Creek Enterprises
Income Statement
for the Year Ended December 31, 2006
Sales revenue $30,000,000
Less: Cost of goods sold 21,000,000
Gross profits
Creek Enterprises
Balance Sheet
December 31, 2006
Assets Liabilities and Stockholders’ Equity
Current assets Current liabilities
Cash $ 1,000,000 Accounts payable
~The 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. 5Required annual principal payments are $800,000.
Note:
Industry averages appear at the top of page 90.
m
90
PART ONE Introduction to Managerial Finance
Industry averages
Debt ratio 0.51
P2—16 Common-size statement analysis A common-size income statement for Creek Enterprises’ 2005 operations follows. Using the firm’s 2006 income statement presented in Problem 2—15, develop the 2006 common-size income statement and compare it to the 2005 statement. Which areas require further analysis and investigation?
Creek Enterprises
Common-Size Income Statement
for the Year Ended December 31, 2005
Sales revenue ($35,000,000) 100.0%
P2—17 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 the firms’ financial leverage and profitability.
Item Pelican Paper, Inc. Timberland Forest, Inc.
Total assets $10,000,000 $10,000,000
Total equity (all common) 9,000,000 5,000,000
Total sales $25,000,000 $25,000,000
EBIT 6,250,000 6,250,000
Net income 3,690,000 3,450,00
CHAPTER 2 Financial Statements and Analysis
91
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 Timberland’s investors undertake when they choose to purchase its stock instead of Pelican’s?
P2—18 Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in fiscal year 2006. 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, 2006
Sales $40,000,000
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
P2—19 Cross-sectional ratio analysis Use the financial statements on page 92 for Fox Manufacturing Company for the year ended December 31, 2006, along with the industry average ratios also given in what follows, to:
a. Prepare and interpret a complete ratio analysis of the firm’s 2006 operations.
b. Summarize your findings and make recommendations.
$30,000
30,000
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PART ONE Introduction to Managerial Finance
Fox Manufacturing Company
Income Statement
for the Year Ended December 31, 2006
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses General and administrative expenses
Depreciation expense
Total operating expense
Operating profits
Less: Interest expense
Net profits before taxes
Less: Taxes
Net profits after taxes (earnings available for common stockholders)
Earnings per share (EPS)
Fox Manufacturing Company
Balance Sheet
December 31, 2006
Assets
Notes payable
as
Marketable securities
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Liabilities and Stockholders’ Equity
Accounts payable
Accruals
Total current liabilities
Long-term debt
Stockholders’ equity
Common stock equity (20,000 shares outstanding) Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
Note:
Industry averages appear at the top of the facing page.$600,000
460,000
$140,000
60,000
$
80,00010,000
$
70,00027,100
$
42,900$2.15
$
15,0007,200
34,100
82,000
$138,300
270,000
$408,300
$
57,00013,000
5,000
$
75,000$150,000
$110,200
73,100
$183,300
$408,300
Ratio Industry average, 2006
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)
2.35
0.87
4.55
35.8 days
1.09
0.300
12.3
0.202
0.135
0.091
0.099
0.167
$3.10
aBased on a 365-day year and on end-of-year figures.
Zach Industries
Income Statement
for the Year Ended December 31, 2006
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
Net profits after taxes
Zach Industries
Balance Sheet
Assets December 31, 2006
Cash
Total assets
Marketable securities
Accounts receivable
Inventories
Total current assets
Land
Buildings and equipment
Less: Accumulated depreciation Net fixed assets
$160,000
106,000
$
54,000
$
16,00010,000
1,000
10,000
$
37,000$
17,0006,100
$
10,9004,360
$
6,540$ 500
1,000
25,000
45,500
$
72,000$
26,00090,000
38,000
$
78,000$150,000
Liabilities and Stockholders’ Equity
Accounts payable Notes payable
Total current liabilities
Long-term debt
Common stocka
Retained earnings
Total liabilities and stockholders’ equity
$
22,00047,000
$
69,000$
22,950$
31,500$
26,550$150,000
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PART ONE Introduction to Managerial Finance
a. Use the preceding financial statements to complete the following table. Assume that the industry averages given in the table are applicable for both 2005 and 2006.
Ratio
Current ratio
Quick ratio
Inventory turnover’1
Average collection period"
Debt ratio
Times interest earned ratio
Gross profit margin
Net profit margin
Return on total assets
Return on common equity
Marketlbook ratio aBased on a 365-day year and on
Industry
average
1.80
0.70
2.50
37.5 days
65%
3.8
38%
3.5%
4.0%
9.5%
1.1
1.84
0.78
2.59
36.5 days
67%
4.0
40%
3.6%
4.0%
8.0%
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 company’s overall financial condition.P2—21 Integrative—Complete ratio analysis Given the following financial statements (below and on the facing page), historical ratios, and industry averages, calculate Sterling Company’s financial ratios for the most recent year. (Assume a 365-day year.) Analyze its overall financial situation from both a cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firm’s liquidity, activity, debt, profitability, and market.
Sterling Company
Income Statement
for the Year Ended December 31, 2006
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
$
1,300,000200,000
$
1,100,000440,000
$ 660,000
50,000
$
610,000$3.05
Actual 2005 Actual 2006
1.2 _____
CHAPTER 2 Financial Statements and Analysis
95
Sterling Company
Balance Sheet
December 31, 2006
Liabilities and Stockholders’ Equity
Assets
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)a $12,000,000
Less: Accumulated depreciation 3,000,000
Net fixed assets
Other assets
Total assets
$
200,00050,000
800,000
950,000
$
2,000,000
$
9,000,000$
1,000,000$12,000,000
Current liabilities
Accounts payableb
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases(~
Stockholders’ equity
Preferred stock (25,000 shares, $2 dividend)
Common stock (200,000 shares at $3 par)d
Paid-in capital in excess of par value
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
$
900,000200,000
100,000
$
1,200,000$
3,000,000
$
1,000,000600,000
5,200,000
1,000,000
$
7,800,000$12,000,000
"The 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. 5Annual credit purchases of $6,200,000 were made during the year.
‘The annual principal payment on the long-term debt is $100,000.
d00 December 31, 2006, the firm’s common stock closed at $39.50 per share.
Ratio
Historical and Industry Average Ratios for Sterling Company
Actual 2004 Actual 2005 Industry average, 2006
Current ratio
Quick ratio
Inventory turnover
Average collection period
Average payment period
Total asset turnover
Debt ratio
Times interest earned ratio
Fixed-payment coverage ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets (ROA)
Return on common equity (ROE)
Earnings per share (EPS)
Price/earnings (P/E) ratio
Market/book (M/B) ratio
1.40
1.00
9.52
45.6 days
59.3 days
0.74
0.20
8.2
4.5
0.30
0.12
0.062
0.045
0.061
$1.75
12.0
1.20
1.55
0.92
9.21
36.9 days
61.6 days
0.80
0.20
7.3
4.2
0.27
0.12
0.062
0.050
0.067
$2.20
10.5
1.05
1.85
1.05
8.60
35.5 days
46.4 days
0.74
0.30
8.0
4.2
0.25
0.10
0.053
0.040
0.066
$1.50
11.2
1.10
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PART ONE Introduction to Managerial Finance
P2—22 DuPont system of analysis Use the following ratio information for Johnson
International and the industry averages for Johnson’s 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?
Financial leverage multiplier
Net profit margin
Total asset turnover
Industry Averages
Financial leverage multiplier
Net profit margin
Total asser turnover
1.75
0.059
2.11
1.67
0.054
2.05
1.75
0.058
2.18
1.85
0.049
2.34
1.64
0.041
2.15
P2—23 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 2005 and 2006. She will use them to look for significant changes in the company’s situation from one year to the next.
Ratio
Current ratio
Quick ratio
Debt ratio
Home Health, Inc.
Financial Ratios
2005
Inventory turnover
Average collecrion period
Total asset turnover
Times interest earned ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets
Return on common equity
Price/earnings ratio
Market/book ratio
3.25
2.50
12.80
42.6 days
1.40
0.45
4.00
68%
14%
8.3%
11.6%
21.1%
10.7
1.40
2006
3.00
2.20
10.30
31.4 days
2.00
0.62
3.85
65%
16%
8.1%
16.2%
42.6%
9.8
1.25
a. To focus on the degree of change, calculate the year-to-year proportional change by subtracting the year 2005 ratio from the year 2006 ratio, then dividing the difference by the year 2005 ratio. Multiply the result by 100.
Johnson
2004 2005 2006
1.69
0.047
2.13
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97
Preserve the positive or negative sign. The result
is the percentage change in the ratio from 2005 to 2006. 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 company’s 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.
P2—24 ETHICS PROBLEM Do
some reading in periodicals and/or on the Internet to find out more about the Sarbanes-Oxley Act’s provisions for companies. Select one of those provisions, and indicate why you think financial statements will be more trustworthy if company financial executives implement this provision of SOX.
Chapter
2 Case: Assessing Martin Manufacturing’s Current Financial PositionT
erri Spiro, an experienced budget analyst at Martin Manufacturing Company, has been charged with assessing the firm’s financial performance
during 2006 and its financial position at year-end 2006. To complete this assignment, she gathered the firm’s 2006 financial statements (below and on page 98). In addition, Tern obtained the firm’s ratio values for 2004 and 2005, along with the 2006 industry average ratios (also applicable to 2004 and 2005). These are presented in the table on page 99.
Martin Manufacturing Company
Income Statement
for the Year Ended December 31, 2006
Sales revenue $5,075,000
$0.33
Earnings per share (EPS(
98
PART ONE Introduction to Managerial FinanceAssets
Current assets
Cash
Total assets
Martin Manufacturing Company
Balance Sheets
December 31
2006 2005
Accounts receivable Inventories
Total current assets
Gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
$
25,000805,556
700,625
$1,531,181
$2,093,819
500,000
$1,593,819
$3,125,000
$
24,100763,900
763,445
$1,551,445
$1,691,707
348,000
$1,343,707
$2,895,152
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
Stockholders’ equity
Preferred stock (2,500 shares, $1.20 dividend)
Common stock (100,000 shares at $4 par)a
Paid-in capital in excess of par value
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
$
230,000311,000
75,000
$
616,000$1,165,250
$1,781,250
$
50,000400,000
593,750
300,000
$1,343,750
$3,125,000
$
400,500$1,571,402
$
50,000400,000
593,750
280,000
$1,323,750
$2,895,152
‘The firm’s 100,000 outstanding shares of common stock closed 2006 at a price of $11.38 per share.
CHAPTER 2 Financial Statements and Analysis
99
Ratio
Current ratio Quick ratio
Debt ratio
Inventory turnover (times)
Average collection period
Total asset turnover (times)
Times interest earned ratio
Gross profit margin
Net profit margin
Return on total assets )ROA)
Return on common equity (ROE)
Price/earnings )P/E) ratio
Market/book (MIB) ratio
Martin Manufacturing Company Historical and Industry Average Ratios
Actual Actual Actual Industry average
2004 2005 2006 2006
1.7 1.8
1.0 0.9
5.2 5.0
50.7 days 55.8 days
1.5 1.5
45.8%
2.2
27.5%
1.1%
1.7%
3.1%
33.5
1.0
54.3%
1.9
28.0%
1.0%
1.5%
3.3%
38.7
1.1
a. Calculate the firm’s 2006 financial ratios, and then (Assume a 365-day year.)
b. Analyze the firm’s current financial position from both a cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firm
s liquidity, activity, debt, profitability, and market.c. Summarize the firm’s overall financial position on the basis of your findings in part b.
fill in the preceding table.
Spreadsheet Exercise
The income statement and balance sheet are the basic reports that a firm constructs for use
by management and for distribution to stockholders, regulatory bodies, and the general public. They are the primary sources of historical financial information about the firm. Dayton Products, Inc., is a moderate-sized manufacturer. The company’s management has asked you to perform a detailed financial statement analysis of the firm.The income statement data for the years ending December 31, 2006 and 2005, respectively, is presented in the table at the top of page 100.
(Note:Purchases of inventory during 2006 amounted to $109,865.)
1.5
1.2
10.2
46 days
2.0
24.5%
2.5
26.0%
1.2%
2.4%
3.2%
43.4
1.2
TO DO
100 PART ONE
Introduction to Managerial Finance
Annual Income Statement
(Values in millions)
For the year ended
December 31, December 31,
2006 2005
Sales
Cost of goods sold
Selling, general, and administrative expenses
Other tax expense
Depreciation and amortization
Other income (add to EBIT to arrive at EBT(
Interest expense
Income tax rate (average)
Dividends paid per share
Basic EPS from total operations
$178,909.00
12,356.00
33,572.00
12,103.00
3,147.00
398
35.324%
$1.47
$1.71
$187,510.00
111,631.00
12,900.00
33,377.00
7,944.00
3,323.00
293
37.945%
$0.91
$2.25
You also have the following balance sheet information as 2006 and 2005, respectively.
Annual Balance Sheet (Values in millions)
Cash and equivalents
Inventories
Other current assets
Property, plant, and equipment, gross
Accumulated depreciation and depletion
Other noncurrent assets
Accounts payable
Short-term debt payable
Other current liabilities
Long-term debt payable
Deferred income taxes
Other noncurrent liabilities
Retained earnings
Total common shares outstanding
of December 31,
December 31, December, 31,
2006 2005
$ 7,229.00 $ 6,547.00
$13,792.00 $22,862.00
4,093.00 3,703.00
15,290.00 3,549.00
6,655.00 7,099.00
16,484.00 16,359.00
21,733.00 16,441.00
$74,597.00 $73,161.00
6.7 billion 6.8 billion
TO DO
a. Create a spreadsheet similar to the spreadsheet in Table 2.1 (which can be viewed at
\vww.aw-bc.cotllIgitJnan) to model the following:(1) A multiple-step comparative income statement for Dayton, Inc., for the periods ending December 31, 2006 and 2005. You must calculate the
cost of goods sold for the year 2006.
(2) A common-size income statement for Dayton, Inc., covering the years 2006 and 2005.
Receivables
CHAPTER 2 Financial Statements and Analysis
101
b. Create a spreadsheet similar to the spreadsheet in Table 2.2 (which can be viewed at
www.a\v-bc.cornlgitman) to model the following:(1) A detailed, comparative balance sheet for Dayton, Inc., for the years ended December 31, 2006 and 2005.
(2) A common-size balance sheet for Dayton, Inc., covering the years 2006 and 2005.
c. Create a spreadsheet similar to the spreadsheet in Table 2.8 (which can be viewed at
w\v\v.aw-hc.comlgitman) to perform the following analysis:(1) Create a table that reflects both 2006 and 2005 operating ratios for Dayton, Inc., segmented into (a) liquidity, (b) activity, (c) debt, (d) profitability, and (e) market. Assume that the current market price for the stock is $90.
(2) Compare the 2006 ratios to the 2005 ratios. Indicate whether the results "outperformed the prior year" or "underperformed relative to the prior
year."
I
Group ExerciseThis assignment will focus on your group’s shadow corporation. As in Chapter 1, the group will be asked to utilize the latest 10-K filing.
TO DO
a. Access the latest 10-K filing. Describe the content of the letter to stockholders.
b. Calculate the basic ratios as done in the text. Sort the ratios into the five categories found in Table 2.8 (pages
72 and 73).c. State what use each ratio has in analyzing the health of your corporation.
d. Analyze these ratios through time by calculating them over the most recent years. For any ratios that have changed, give possible explanations as to why these changes may have occurred.
e. Conclude with a financial summary of the ratios using the DuPont system.
Web Exercise
For this assignment, you will need a Web-based search engine such as Google.
TO DO
a. Enter the term "stock market" as a search keyword. Scan the results for the New York Stock Exchange and Nasdaq home sites. Compare and contrast the two stock markets’ home pages.
b. Return to your search engine and search for "financial markets." Report on your findings, including a synopsis of a free site that you feel had very usable financial market news and analysis. This site should be used as a source of information in future assignments, so spend some time looking for a good site.
Remember to check the book’s Web site at
www.aw-bc.com/gitman
for additional resources, including additional Web exercises.