Chapter 3

Introduction to Financial Statement Analysis

SOLUTIONS 1. One purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas. Another purpose of financial statement analysis is to use the past performance of a company to predict how it will do in the future. Disagree. An analysis of a companys financial ratios usually does not provide detailed information about what the causes of a companys problems are, but it does identify areas in which more detailed data should be gathered. The usefulness of financial ratios is greatly enhanced when they are compared with past values for the same company and with values for other firms in the same industry. Current ratio is a measure of a companys liquidity, which is the companys ability to pay its debts in the short run. It is impossible to tell whether Company As return on sales of 6% is high or low. The return on sales value must be analyzed in light of the appropriate industry. For example, a normal return on sales for supermarkets is around 1% or 2%, whereas the return on sales for a high-tech company such as Microsoft can be in excess of 30%. The price-earnings ratio differs from most other financial ratios in that it is not the ratio of two financial statement numbers. Instead, PE ratio is a comparison of a financial statement number to a market value number. A common-size financial statement is a financial statement with all numbers for a given year divided by a common denominator for that statement. For example, on a common-size income statement, all amounts for a given year are shown as a percentage of sales for that year. Common-size financial statements make it possible to make comparisons even when the size of companies is different. In addition, common-size financial statements allow comparison of a companys numbers to equivalent numbers in prior years when the sales or total assets level may have been much different. If an analysis of common-size financial statements suggests that a company has problems, the way to find out what is causing these problems is to gather information from outside the financial statementsask management, read press releases, talk to financial analysts who follow the firm, read industry newsletters, and dig into the notes to the financial statements. The most informative section of the common-size balance sheet is the asset section. This section can be used to determine how efficiently a company is using its assets. The DuPont framework provides a systematic approach to identifying general factors causing ROE to deviate from normal. The DuPont system also provides a framework for computation of financial ratios to yield more in-depth analysis of a companys areas of strength and weakness.

2.

3. 4. 5.

6.

7.

8.

9. 10.

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11.

With the DuPont framework, ROE is decomposed into three componentsprofitability, efficiency, and leverage. The ratios summarizing a companys performance in each area are as follows: Profitability: Return on sales = Net income / Sales Efficiency: Asset turnover = Sales / Assets Leverage: Assets-to-Equity ratio = Assets / Equity If a DuPont analysis suggests problems in any of the three ROE components, further ratios, specific to each area, can be computed to shed more light on the exact nature of the problem. For example, a common-size income statement can shed further light on the cause of a profitability problem. If a company has a high average collection period, it then has a large amount of resources tied up in the form of accounts receivable. Those resources might be more appropriately used in another area of the business. If a company has a low average collection period, it has the benefit of quickly getting its cash from its customers, but it also runs the risk of driving away customers who wanted to take a little longer to pay. Average asset balances are often used in computing financial ratios because of the desire to compare income statement numbers, which arise from transactions made throughout the year, with the average level of assets outstanding throughout the year. The ending balance in an asset account may not be a good reflection of the normal asset balance prevailing during the year. Turnover is the degree to which assets are used to generate sales. Companies with a low margin, or profit on each dollar of sales, can still earn an acceptable level of return on assets if they have a high asset turnover. Return on assets is equal to return on equity when a company has no borrowing, or leverage. In this situation, the investors have put up all of the financing needed to acquire the companys assets. Times interest earned indicates how a companys earnings measure up to the amount of interest the company is expected to pay. In contrast, the debt ratio and the debt-to-equity ratio yield information on the relative size of a companys assets and liabilities. The requirement that companies provide a cash flow statement is relatively recent. Because of this, cash flow ratios often do not get the emphasis they deserve in financial analysis models. Accrual accounting involves making assumptions in order to adjust the raw cash flow data into a better measure of economic performance called net income. For companies entering phases where it is critical that reported earnings look good, such as a firm that is preparing to make an application for a large loan, those accounting assumptions and adjustments can be stretched. Accordingly, cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for reported earnings. When the value of a companys cash flow adequacy ratio is less than one, that company is not generating enough cash from operations to pay for all new plant and equipment purchases. Accordingly, the company has no cash left over to repay loans or to distribute to investors. Comparability among financial statements is reduced when companies classify items differently in the financial statements and when companies use different accounting practices. In addition,
Chapter 3 2

12.

13.

14.

15.

16.

17.

18. 19.

20.

21.

when a company is composed of a variety of divisions, each operating in a different line of business, it is difficult to find appropriate industry comparison values with which to benchmark the companys ratios. 22. One danger in focusing a financial analysis solely on the data found in the historical financial statements is that one might then tend to focus on the companys past performance and ignore current year information.

EXERCISES E 3-1 Computation of Ratios 1. 2. 3. 4. 5. 6. Debt ratio = $85,000 / $215,000 = 39.5% Current ratio = $70,000 / $45,000 = 1.56 Return on sales = $30,000 / $340,000 = 8.8% Asset turnover = $340,000 / $215,000 = 1.58 Return on equity = $30,000 / $130,000 = 23.1% Price-earnings ratio = $250,000 / $30,000 = 8.33

E 3-2 Ratios and Computing Missing Values b. a. c. d. f. e. i. h. g. Current ratio = Total current assets / Total current liabilities 1.5 = (b) / $40,000; (b) = $60,000 Cash + Accounts receivable = Total current assets (a) + $50,000 = $60,000; (a) = $10,000 Total assets = Current assets + Long-term assets (c) = $60,000 + $40,000 + $100,000 = $200,000 Total current liabilities = Accounts payable + Income taxes payable $40,000 = $30,000 + (d); (d) = $10,000 Debt ratio = Total liabilities / Total assets 0.60 = (f) / $200,000; (f) = $120,000 Total liabilities = Current liabilities + Long-term liabilities $120,000 = $40,000 + (e); (e) = $80,000 Total liabilities and stockholders equity = Total assets (i) = $200,000 Total liabilities and stockholders equity = Total liabilities + Total stockholders equity $200,000 = $120,000 + (h); (h) = $80,000 Total stockholders equity = Paid-in capital + Retained earnings $80,000 = (g) + $35,000; (g) = $45,000

In order, the answers are: a. b. c. d. e. f. g. h. i. $10,000 $60,000 $200,000 $10,000 $80,000 $120,000 $45,000 $80,000 $200,000

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E 3-3 Computations Using Ratios 1. Total assets Debt ratio = Total liabilities / Total assets 0.40 = $100,000 / Total assets Total assets = $250,000 Sales Asset turnover = Sales / Total assets 2.0 = Sales / $250,000 Sales = $500,000 Net income Return on sales = Net income / Sales 0.10 = Net income / $500,000 Net income = $50,000 Price-earnings ratio Price-earnings ratio = Market value / Net income Price-earnings ratio = $600,000 / $50,000 Price-earnings ratio = 12

2.

3.

4.

E 3-4 Common-Size Income Statement MacDonald Company 1. 2006 Sales $820,000 Cost of goods sold 515,000 Gross profit on sales $305,000 Selling and general expenses 110,000 Operating income $195,000 Interest expense 45,000 Income before income tax $150,000 Income tax expense 45,000 Net income $105,000 *Subtraction difference due to percentage rounding. % 100.0 62.8 37.2 13.4 23.8 5.5 18.3 5.5 12.8 2005 $465,000 250,000 $215,000 70,000 $145,000 35,000 $110,000 33,000 $ 77,000 % 100.0 53.8 46.2 15.1 31.2* 7.5 23.7 7.1 16.6

2.

Return on sales for MacDonald in 2006 is 12.8% compared to 16.6% in 2005. The cause of the decrease in the return on sales is that cost of goods sold as a percentage of sales is much higher in 2006 (62.8%) compared to 2005 (53.8%). This increase is partially offset by lower selling and general expenses, lower interest expense, and lower income tax expense in 2006.

E 3-5 Common-Size Balance Sheet Warren Road Company 1. Cash Accounts receivable Inventories Property, plant, and equipment Total assets Sales 2006 $ 34,000 43,000 68,000 91,000 $ 236,000 $1,000,000
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% 3.4 4.3 6.8 9.1 23.6

2005 $ 25,000 40,000 30,000 55,000 $150,000 $800,000

% 3.1 5.0 3.8 6.9 18.8

2.

Total assets as a percentage of sales for Warren Road in 2006 are 23.6% compared to 18.8% in 2005. This means that Warren Road needed more assets in place in 2006 to generate $1 of sales than in 2005. Both inventories and property, plant, and equipment increased substantially as a percentage of sales in 2006.

E 3-6 Income Statement Analysis 1. = Sales Gross profit percentage = $360,000 40% = $144,000 Cost of goods sold = Sales Gross profit = $360,000 $144,000 = $216,000 Net income = Sales Return on sales = $360,000 7.5% = $ 27,000 Operating expenses = Sales 30% = $360,000 0.30 = $108,000 Sales Cost of goods sold Operating expenses Income taxes = Net income $360,000 $216,000 $108,000 Income taxes = $27,000 Income taxes = $ 9,000 Gross profit

2.

3.

4.

E 3-7 Income Statement and Balance Sheet Analysis a. b. Return on equity = Net income / Stockholders equity Return on equity = ($25,000/$700,000) = 3.6% The current ratio at the beginning of 2006 was 1.27, while at the end of 2006 it was 1.15. The current ratio decreased by 0.12. 1.27 = $672,000/$531,000 1.15 = $790,000/$685,000 Given: Hence: Given: Total liabilities + Stockholders equity Total assets = $500,000 Current assets = 20% of total assets = $500,000 20% = $100,000 = $500,000

c.

(1) Given: That is:

Current ratio = 1.25 (Current assets/Current liabilities) = 1.25 Current liabilities = Current assets/1.25 = $100,000/1.25 = $80,000 Stockholders equity/Total liabilities Stockholders equity Also: Stockholders equity + Total liabilities Or:4 Total liabilities + Total liabilities Total liabilities Debt ratio =4 = 4 Total liabilities = $500,000 = $500,000 = $100,000 = $100,000/$500,000

(2) Given:

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= 20%

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E 3-8 DuPont Framework 2006 1. 2. 3. 4. Return on equity (Net income / Stockholders equity) Return on sales (Net income / Sales) Asset turnover (Sales / Total assets) Assets-to-equity ratio (Total assets / Stockholders equity) Iffy 120 600 480 3,440 4,640 Return on Sales 1.0% ($100/$10,000) 4.0% ($3,000/$75,000) 41.2% 6.4% 4.23 1.53 2005 31.4% 5.1% 3.91 1.57 2004 44.4% 6.7% 3.33 2.00

E 3-9 DuPont Framework 1. Cash Accounts receivable Inventory Property, plant, and equipment Total assets ROE = Iffy Model 2. 6.9% ($100/$1,450) 36.4% ($3,000/$8,250)

Model 900 4,500 6,000 15,000 26,400 Asset Turnover 2.16 ($10,000/$4,640) 2.84 ($75,000/$26,400) Assets/Equity 3.20 ($4,640/$1,450) 3.20 ($26,400/$8,250)

Iffys return on equity of 6.9% is lower than Models return on equity of 36.4% because Iffy is both less profitable and less efficient than Model. Iffys return on sales is only 1.0%, compared to 4.0% for Model, indicating that each dollar in sales is four times as profitable for Model than for Iffy. In addition, Iffys asset turnover of 2.16 is less than Models asset turnover of 2.84, indicating that Iffy is less efficient at using its assets to generate sales. The level of leverage for Iffy and Model is the same. Question 60 600 1,400 1,000 3,060 2,448 612 10,000 7,350 700 1,900 50 Standard 300 4,000 3,650 8,650 16,600 13,280 3,320 50,000 36,750 3,500 8,500 1,250
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E 3-10 DuPont Framework 1. Cash Accounts receivable Inventory Property, Plant, and Equipment Total assets Total liabilities Stockholders equity Sales Cost of goods sold Wage expense Other expenses Net income

ROE = Question Standard 2. 8.2% ($50/$612) 37.7% ($1,250/$3,320)

Return on Sales 0.5% ($50/$10,000) 2.5% ($1,250/$50,000)

Asset Turnover 3.27 ($10,000/$3,060) 3.01 ($50,000/$16,600)

Assets/Equity 5.00 ($3,060/$612) 5.00 ($16,600/$3,320)

Questions return on equity of 8.2% is lower than Standards return on equity of 37.7% because Question is less profitable than is Standard. Questions return on sales is only 0.5%, compared to 2.5% for Standard, indicating that each dollar in sales is less profitable for Question. The level of leverage for Question and Standard is the same. Question is slightly more efficient at using its assets to generate sales.

E 3-11 DuPont Framework 1. Return on assets = Net income/Total assets = (Net income/Sales) (Sales/Total assets) = Return on sales Asset turnover Return on Sales 5.3% 1.6% 6.3% 8.7% Asset Turnover = 1.777 5.844 0.601 3.468 Return on Assets 9.4% 9.4% 3.8% 30.2%

Retail jewelry stores Retail grocery stores Electric service companies Legal services firms 2.

Return on equity = Net income/Stockholders equity = (Net income/Sales) (Sales/Total assets) (Total assets/Stockholders equity) = Return on sales Asset turnover Assets-to-equity ratio Return on Sales 5.3% 1.6% 6.3% 8.7% Asset Turnover 1.777 5.844 0.601 3.468 AssetstoEquity = 1.427 1.910 2.639 1.684 Return on Equity 13.4% 17.9% 10.0% 50.8%

Retail jewelry stores Retail grocery stores Electric service companies Legal services firms

E 3-12 Ratios for receivables, inventory, and fixed assets 1. Sales................................................................................. Accounts receivable: Beginning of year.....................................................$ End of year...............................................................$ Average accounts receivable [(beginning balance + ending balance) 2].......................................$ Accounts receivable turnover....................................5.09
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2006 $ 140,000 25,000 30,000 27,500 times $ $ $

2005 $ 105,000 5,000 25,000 15,000

7.00 times

2006 Average accounts receivable..........................................$ Sales...............................................................................$ Average daily sales (sales 365)....................................$ Average collection period................................................. 2. Cost of goods sold..........................................................$ 27,500 $

2005 15,000 105,000 288 52.1days 2005 70,000 20,000 15,000 17,500

140,000 $ 384 $ 71.6 days 2006 100,000 $

Inventory: Beginning of year....................................................... $15,000 $ End of year...............................................................$ 35,000 $ Average inventory [(beginning balance + ending balance) 2] $25,000 $ Inventory turnover............................................................

4.00 times4.00 times 2006 2005 $ 17,500 70,000 192* 91.2 days 2005 $ $ $ $ 105,000 85,000 80,000 82,500

Average inventory..........................................................$ Cost of goods sold..........................................................$ Average daily CofGS (CofGS 365).............................$ Number of days sales in inventory.................................. * rounding difference 3.

25,000

100,000 $ 274 $ 91.2 days 2006

Sales...............................................................................$140,000 Property, plant, and equipment: Beginning of year.....................................................$ End of year..............................................................$ Average fixed assets [(beginning balance + ending balance) 2].......................................$ Fixed asset turnover.......................................................... E 3-13 Margin and Turnover Return on Sales Company A: $125,000 $6,000,000 2.08% $600,000 $6,000,000 10.00% Asset Turnover = $6,000,000 $1,200,000 5.0 $6,000,000 $6,000000 1.0 = = = = = = 80,000 105,000 92,500

1.51 times1.27 times Return on Assets $125,000 $1,200,000 10.42% $600,000 $6,000,000 10.00%

Company B:

Company A is the discount store since it has the greater asset turnover.

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Company B is the gift shop since it has the greater profit percentage. E 3-14 Leverage Ratios 1. a. b. c. Applicant X Debt ratio (Total liabilities / Total assets) 37.5% Debt-to-equity ratio (Total liabilities / Total owners equity) 0.60 Times interest earned 6.71 times (Earnings before interest and taxes / ($47,000/$7,000) interest expense) or (Net income + income tax expense + interest expense /interest expense) Applicant Y 71.4% 2.50 2.76 times ($81,500/$29,500)

2.

Applicant X is the more attractive loan candidate. Applicant X has borrowed a smaller proportion of its past financing, making it less likely that a decline in asset value will reduce the value of its assets below the amount of its liabilities. In addition, Applicant X is able to cover its existing interest expense almost seven times with its existing earnings before interest and taxes, compared to just 2.76 times for Applicant Y.

E 3-15 Financial Statement Analysis The easiest way to approach this exercise is to prepare the income statement. Marigold Company Income Statement For the Year Ended December 31, 2006 Sales Cost of goods sold Gross profit on sales Operating expenses: Other operating expenses General and administrative expense Total operating expenses Income from operations Other expenses: Interest Income before taxes Taxes Net income Answers to specific questions: 1. 2. 3. 4. 5. 6. 7. 8. Gross profit on sales= $330,000 Income from operations = $87,500 Other operating expenses = $187,500 Amount needed to make total operating expenses = $242,500 Gross profit percentage = $330,000/ $830,000 = 39.76% Total assets = $66,000/0.025 = $2,640,000 Stockholders equity = $66,000/0.05 = $1,320,000 Return on sales = $66,000/$830,000 = 7.95% Income tax rate = $16,500/$82,500 = 20% $830,000 500,000 $330,000 $187,500 55,000 242,500 $ 87,500 5,000 $ 82,500 16,500 $ 66,000

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E 3-16 Cash Flow Ratios 2006 1. 2. 3. Cash flow to net income ratio 0.63 (CFO / Net income) Cash flow adequacy ratio 0.61 (CFO / Cash paid for purchase of fixed assets) Cash times interest earned ratio 2.62 ((CFO + Cash paid for interest and taxes) / Cash paid for interest) 2005 2.22 0.85 8.47

PROBLEMS P 3-17 Computing and Using Common Ratios 1. a. b. Current ratio (Current assets/current liabilities) Debt ratio (Total liabilities/Total assets) Total liabilities = Current liabilities + Long-term liabilities Total assets = Current assets + Long-term assets Return on sales (Net income/Sales) Asset turnover (Sales/Total assets) Return on equity (Net income/Total equity) Total equity = Total assets Total liabilities Price-earnings ratio (Market value/Net income) Market value = Price per share Number of shares Millard 2.50 38.3% Grantsville 1.25 79.1%

c. d. e. f.

2.0% 3.33 10.8% 22.5

1.2% 3.95 22.2% 15.0

2.

ANALYSIS: There are many signs that Millard Company is not being managed aggressively enough. First of all, Millard has a high current ratio of 2.50, compared to the 1.25 current ratio of its competitor Grantsville. This is a sign that Millard may have excess current assets. In addition, Millard has a relatively low debt ratio (38.3% compared to 79.1% for Grantsville). This indicates that Millard has not leveraged its stockholders investment as much as has Grantsville. Finally, Millards overall asset turnover is lower than Grantsvilles (3.33 vs. 3.95), indicating that Millard is not using its assets to generate sales as efficiently as is Grantsville. Overall, Millard has a significantly lower return on equity than does Grantsville (10.8% vs. 22.2%). One indication that the aggressive strategy practiced by Grantsville may have some weaknesses is Grantsvilles lower PE ratio. Millards PE ratio is 22.5, compared to just 15.0 for Grantsville. This suggests that investors are more optimistic about future earnings growth by Millard.

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P 3-18 Working Backwards Using Common Ratios 1. a. Return on equity = = = Net income / Stockholders equity $32,000 / $100,000 32.0%

b.

Total assets If debt ratio (total liabilities/total assets) is 75%, then the ratio (stockholders equity/total assets) is 25% since total assets is the sum of total liabilities and stockholders equity. 0.25 = Stockholders equity / Total assets 0.25 = $100,000 / Total assets Total assets = $400,000 Sales Asset turnover 0.8 Sales Return on sales = = = = = = = = = = = = Sales / Total assets Sales / $400,000 $320,000 Net income / Sales $32,000 / $320,000 10% Current assets / current liabilities Current assets + long-term assets Current assets + $310,000 $90,000 $90,000 / $115,000 0.78

c.

d.

e.

Current ratio Total assets $400,000 Current assets Current ratio

f.

Total market value of shares PE ratio = Market value / Net income 42.0 = Market value / $32,000 Market value = $1,344,000 ANALYSIS: Book-to-market ratio = = = Stockholders equity / Market value $100,000 / $1,344,000 0.07

2.

A low book-to-market ratio is indicative of a company that has a large proportion of its value in the form of assets not reported in the balance sheet. So, for example, it is possible that Francis Company has a large number of unreported intangible assets. In addition, a low book-to-market ratio indicates a company that is using its assets in very innovative ways such that market participants expect the company to earn an above-average rate of return for many years into the future.

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P 3-19 Common-Size Income Statement 1. Karl Company Common-Size Income Statements For the Years Ended December 31, 2006 and 2005 2006 Amount Net sales $300,000 Cost of goods sold 218,750 Gross profit on sales $81,250 Selling and general expenses 62,500 Operating income $18,750 Interest expense 21,875 Income (loss) before income tax $ (3,125) Income tax (refund) (1,250) Net income (loss) $ (1,875) Note: Percentages dont add up because of rounding 2. Percent 100% 73% 27% 21% 6% 7% (1%) (0%) (1%) Amount $275,000 150,000 $125,000 75,000 $50,000 18,750 $31,250 12,500 $18,750 2005 Percent 100% 55% 45% 27% 18% 7% 11% 5% 7%

The Karl Company is having a severe problem with its cost of goods sold. The decrease in gross profit percentage from 45% to 27% is a significant drop. If Karl is a manufacturing company, there may be excess spoilage or quality problems in production. As a result of the cost problem, Karl experienced a net loss in 2006 as opposed to a significant net income in 2005. A detailed examination of cost of goods sold is necessary to complete this evaluation. ANALYSIS: Both operating income and interest expense are measured using the concepts of accrual accounting. Accordingly, the reported accrual numbers can be more or less than the associated cash flow. For example, the actual cash payments for interest required in 2006 may have been less than the $21,875 in reported interest expense. A comparison of cash paid for interest and cash from operations (before interest and taxes) would reveal whether Karls operations generated enough cash in 2006 to make the necessary interest payments. Even if the cash generated was insufficient to pay the required amount of interest, Karl could acquire the necessary cash through borrowing or through liquidating existing assets.

3.

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P 3-20 Common-Size Financial Statements 1. Wong Shek Company Common-Size Financial Statements For 2005 and 2006 2006 Amount Cash Receivables Inventory Property, Plant, and Equipment Total Assets Accounts Payable Long-term Debt Total Liabilities Paid-in Capital Retained Earnings Total Liabilities and Equity Sales 100.0 Cost of Goods Sold Gross Profit Operating Expenses (22.9) Operating Profit Interest Expense (3.1) Income before Taxes 2.6 Income Tax Expense (0.9) Net Income 2. 14 35 230 221 500 106 217 323 113 64 500 1,000 (700) 300 (240) 60 (22) 38 (13) 25 % 1.4 3.5 23.0 22.1 50.0 10.6 21.7 32.3 11.3 6.4 50.0 100.0 (70.0) 30.0 (24.0) 6.0 (2.2) 3.8 (1.3) 2.5 2005 Amount 10 27 153 190 380 74 217 291 50 39 380 700 (500) 200 (160) 40 (22) 18 (6) 12 1.7 (71.4) 28.6 % 1.4 3.9 21.9 27.1 54.3 10.6 31.0 41.6 7.1 5.6 54.3

5.7

Wong Shek did better in 2006 than it did in 2005. First of all, from the asset section of the common-size balance sheet, it can be seen that, overall, Wong Shek is using its assets more efficiently in 2006. In 2006, it took only 50.0 cents in assets to generate one dollar in sales whereas it took 54.3 cents in assets in 2005 to generate a dollar of sales. The bulk of this increase in efficiency came through more efficient use of property, plant, and equipment. In addition, Wong Shek is more profitable in 2006 than it was in 2005. The return on sales has increased from 1.7% to 2.5%. The primary cause of this improvement is a reduction in cost of goods sold, evidenced in the increase in the gross profit percentage from 28.6% to 30.0%. In addition, Wong Shek financed its

Chapter 3 14

expansion in 2006 without any additional interest-bearing debt, lowering the interest expense as a percentage of sales.

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3.

ANALYSIS: Below is a comparison of Wong Sheks return on equity depending on whether Wong Shek acquired $63 in external financing in 2006 through stockholder investment (as was actually done) or through borrowing. The following assumptions are made: The interest rate on long-term debt is 10%. The income tax rate is 33%. As Reported Operating profit Less: Interest expense Income before taxes Income tax expense Net income Computation of equity: Paid-in capital Beginning retained earnings Net income for the year Total equity Return on equity (Net income / Equity) $60 (22) $38 (13) $25 $113 39 25 $177 $25/$177 14.1% Borrowing $63 $60 (28) $32 (11) $21 $50 39 21 $110 $21/$110 19.1%

So, the stockholders of Wong Shek are correcttheir return on equity would have been higher if Wong Shek had acquired external financing through borrowing rather than new investment in 2006. P 3-21 Common-Size Financial Statements 1. Clarksville Corporation Common-Size Income Statements For Years Ended December 31 2006 % 2005 % $5,700,000 100.0 4,000,000 70.2 $1,700,000 $1,120,000 400,000 $1,520,000 $ 180,000 80,000 $ 260,000 80,000 $ 180,000 29.8 19.6 7.0 26.7 3.1 1.4 4.5 1.4 3.1 $6,600,000 4,800,000 $1,800,000 $1,200,000 440,000 $1,640,000 $ 160,000 130,000 $ 290,000 85,000 $ 205,000 100.0 72.7 27.3 18.2 6.7 24.9 2.4 2.0 4.4 1.3 3.1

2004 $3,800,000 2,520,000 $1,280,000 $ 960,000 400,000 $1,360,000 $ (80,000) 160,000 $ 80,000 20,000 $ 60,000

% 100.0 66.3 33.7 25.3 10.5 35.8 (2.1) 4.2 2.1 0.5 1.6

Net sales Cost of goods sold Gross profit on sales Selling expense General expense Total operating expenses Operating income (loss) Other revenue (expense) Income before taxes Income tax Net income

Minor adjustments to the percentage computations have been made to counteract the cumulative effect of rounding.

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Clarksville Corporation Common-Size Balance Sheets December 31 2006 Assets Current assets 673,500 Land, building, and equipment Intangible assets Other assets Total assets Liabilities Current liabilities 130,000 Long-term liabilities Total liabilities 530,000 Stockholders Equity Paid-in capital 1,000,000 Retained earnings Total stockholders equity 1,230,000 Total liabilities and stockholders equity 1,760,000 % 2005 $ 955,500 1,075,000 100,000 60,500 $2,191,000 $ 501,000 600,000 $1,101,000 % 14.5 16.3 1.5 0.9 33.2 7.6 9.1 16.7 $ 925,000 100,000 61,500 $1,760,000 $ 400,000 $ 46.3 2004 %

$ 855,000 15.0 17.7 1,275,000 24.4 100,000 2.6 48,000 1.6 $2,278,000 $ 410,000 3.4 400,000 10.5 22.4 1.8 0.8 40.0 7.2 7.0

$ 810,000 14.2 13.9 $1,100,000 19.3 26.3 368,000 6.5 $1,468,000 25.8 32.4 $2,278,000 40.0 46.3

$ 800,000 290,000 $1,090,000 $2,191,000

12.1 4.4 16.5 33.2

$ 230,000 $ $ 6.1

Minor adjustments to the percentage computations have been made to counteract the cumulative effect of rounding. 2. The common-size information reveals that, in 2004, an item selling for $1.00 yielded an average gross profit of 33.7 cents; in 2006, an item selling for $1.00 yielded an average gross profit of only 29.8 cents. The good news is that gross profit as a percentage of sales is improved in 2006 relative to 2005 (27.3%). In 2006, bottom line net income was 3.1% of sales, compared to just 1.6% in 2004. Total operating expenses were 35.8% of sales in 2004, compared to just 26.7% in 2006. The most informative section of the common-size balance sheet is the asset section, which can be used to determine how efficiently a company is using its assets. The common-size balance sheet indicates that each dollar of sales in 2005 required assets in place of 33.2 cents, whereas each dollar of sales in 2006 required assets of 40.0 cents. So, Clarksville was more efficient at using its assets to generate sales in 2005 when each dollar of sales required a lower level of assets. Examination of the individual asset accounts suggests that the primary reason for less efficient total asset usage in

Chapter 3 17

2006 is land, building, and equipmenta dollar of sales in 2005 required only 16.3 cents of land, building, and equipment, compared to 22.4 cents in 2006. 3. ANALYSIS: Stock prices are based on how investors think that a company will perform in the future. As a result, Clarksvilles stock price may have declined in 2006. The reason for this is that 2006 was a mild disappointment, especially following the optimistic view that was created by Clarksvilles good performance in 2005. In 2005, Clarksville became both more profitable and more efficient, compared to 2004. In 2006, Clarksville declined in efficiency and maintained the same level of overall profitability. This lukewarm news may have caused expectations about the future to decline, resulting in a lowered stock price. In addition, Clarksvilles total sales declined in 2006, another bad omen for the future. The one piece of good news for Clarksville in 2006 was that operating profitability, as measured by the percentage of operating income divided by sales, increased in 2006. This suggests that the profitability of Clarksvilles core business operations may be improving.

P 3-22 DuPont Analysis 1. (a) Return on sales = Net income/Net sales Company A $6,400 = 16.000% $40,000 (b) Company B $2,775 = 6.607% $42,000 Company C $540 = 1.714% $31,500

Asset turnover = Net sales/Total assets $40,000 $103,600 = 0.386 $42,000 $32,250 = 1.302 $31,500 $4,800

(c)

Assets-to-equity ratio = Total assets/Total equity $103,600 $40,666 = 2.548 $32,250 $16,950 = 1.903 $4,800 $2,535 = 1.893

(d)

Return on assets $6,400 $103,600

= Net income/Total assets, or = Return on sales/Asset turnover $2,775 $32,250 = 8.60% $540 $4,800 = 11.25%

= 6.18%

(e)

Return on equity = Net income/Total equity $6,400 $40,666 = 15.74% $2,775 $16,950 = 16.37% $540 $2,535 = 21.30%

2.

ANALYSIS: The large utility is Company A. (The large investment in assets, the low asset turnover, and high return on sales suggest Company A is the utility.) The large supermarket is Company C. (Company C has a low return on sales and a high asset turnover.) Therefore, the large department store is Company B.

Chapter 3 18

P 3-23 DuPont Analysis 1. a. Return on sales = Net income / Sales 2006 $180,000 $5,700,000 3.16% 2005 $205,000 $6,600,000 3.11% 2004 $60,000 $3,800,000 1.58%

Chapter 3 19

b. Asset turnover = Sales / Total assets 2006 $5,700,000 $2,278,000 2.50 2005 $6,600,000 $2,191,000 3.01 2004 $3,800,000 $1,760,000 2.16

c. Assets-to-equity ratio = Total assets / Stockholders equity 2006 $2,278,000 $1,468,000 1.55 d. Return on assets = Net income / Total assets 2006 $180,000 $2,278,000 7.9% 2005 $205,000 $2,191,000 9.4% 2004 $60,000 $1,760,000 3.4% 2005 $2,191,000 $1,090,000 2.01 2004 $1,760,000 $1,230,000 1.43

e. Return on equity = Net income / Stockholders equity 2006 $180,000 $1,468,000 12.3% 2. 2005 $205,000 $1,090,000 18.8% 2004 $60,000 $1,230,000 4.9%

ANALYSIS: The following computation is an estimate of the level of total assets that would have been required in 2006 if the 2005 asset turnover ratio of 3.01 had also been achieved in 2006: Asset turnover = Sales / Total assets 3.01 = $5,700,000 / Total assets Total assets = $1,893,688 Actual 2006 total assets 2006 total assets if achieve 2005 efficiency Potential reduction in 2006 total assets $2,278,000 1,893,688 $ 384,312

If Clarksville had been able to reduce total assets by $384,312 in 2006, then overall financing needs would have also been reduced by $384,312. This would have allowed Clarksville to reduce its interest-bearing debt, resulting in a reduction in interest expense, an increase in net income, and an increase in profitability.

Chapter 3 20

P 3-24 Analysis of Inventory and Receivables 2006 1. Average collection period: Net sales Accounts receivable: Beginning of year End of year Average accounts receivable Average daily sales (net sales 365) Average collection period Average collection period: Accounts receivable at end of year Average daily sales (net sales 365) Average collection period Number of days sales in inventory: Cost of goods sold Inventory: Beginning of year End of year Average inventory Average daily cost of goods sold (365-day year) Number of days sales in inventory Number of days sales in inventory: Inventory at end of year Average daily cost of goods sold (365-day year) Number of days sales in inventory $320,000 $50,000 $55,000 $52,500 $ 877 59.9 $55,000 $ 877 62.7 $215,000 $ 90,000 $130,000 $110,000 $ 589 186.8 $130,000 $ 589 220.7 2005 $260,000 $20,000 $50,000 $35,000 $ 712 49.2 $50,000 $ 712 70.2 $200,000 $80,000 $90,000 $85,000 $ 548 155.1 $90,000 $ 548 164.2

2.

3.

4.

5.

ANALYSIS: It is more meaningful to compute ratio values using ending asset balances rather than average balances when the item of interest is the level of an asset existing at the end of the year. For example, if a company wants to evaluate its year-end inventory level, the year-end inventory value should be used in computing the number of days sales in inventory. Of course, if the year-end inventory level is used, it would also be appropriate to use average daily cost of goods sold for the most recent period available, such as for the most recent quarter.

P 3-25 Can a Ratio Be Too Good? 1. Shaycoles current ratio is well above the industry norm. This fact would be comforting to Shaycoles short-term creditors, but it also may indicate that Shaycole has an excess of current assets. A firm certainly needs adequate levels of cash, accounts receivable, and inventory, but there is no benefit to be gained from having an excess. Holding an excess of current assets ties up resources that would be better used elsewhere. The low levels of inventory and accounts receivable suggest that the excess current assets are in the form of cash and investment securities. This ratio is usually used to detect sluggish movement in inventory. An increase in the number of days sales in inventory is often an early sign of more serious trouble. However, a number of days sales in inventory that is too low also is a warning signal. If inventory

2.

Chapter 3 21

levels are too low, the firm may be very vulnerable to supplier problems, strikes, and unexpected increases in demand. In todays business world, many companies are trying to minimize inventories using the Just-In-Time philosophy. This will cause a significant decrease in the number of days sales in inventory. 3. Slow receivable collection means that excess funds are tied up in receivables and that the possibility of substantial bad debts is increased. However, receivable collection that is too fast also may indicate potential problems. The credit policy may be too restrictive or the collection policy may be too aggressive, driving away potential customers and alienating existing customers. Again, this ratio is good news to creditors. However, stockholders might not be as pleased. If the firms projects can generate a return that is higher than the cost of debt, it would make sense from the stockholders standpoint to borrow more, thus leveraging their investment and resulting in a higher return for the same investment. ANALYSIS: Shaycole Company can reduce the amount of assets it needs to do business by lowering its excess current assets. As discussed above, these excess current assets appear to be in the form of cash and investment securities. By reducing the level of assets, Shaycole will increase its overall efficiency, reduce its need for external financing, and increase return on equity. In addition, Shaycole is currently obtaining a very small amount of its external financing through borrowing. By increasing its leverage, Shaycole can increase its return on equity.

4.

5.

P 3-26 Ratio Analysis 1. a. b. c. d. e. f. g. h. i. j. k. Ratios Current ratio Debt-to-equity ratio Debt ratio Asset turnover Average collection period Number of days sales in inventory Fixed asset turnover Times interest earned Return on sales Return on assets Return on equity a. b. c. d. e. Calculations Current ratio 2006: $548,000/$90,000 2005: $486,000/$66,000 Debt-to-equity ratio 2006: $308,000/$320,000 2005: $266,000/$300,000 Debt ratio 2006: $308,000/$628,000 2005: $266,000/$566,000 Asset turnover 2006: $1,000,000/$628,000 2005: $860,000/$566,000 Average collection period 2006: $8,000/($1,000,000/365) 2006 6.1 0.96 49.0% 1.59 2.9 398.2 12.5 14.5 18.0% 28.7% 56.3% 2005 7.4 0.89 47.0% 1.52 5.9 436.0 10.8 16.6 19.8% 30.0% 56.7%

Chapter 3 22

f. g. h. i. j. k.

2005: $14,000/($860,000/365) Number of days sales in inventory 2006: $480,000/($440,000/365) 2005: $430,000/($360,000/365) Fixed asset turnover 2006: $1,000,000/$80,000 2005: $860,000/$80,000 Times interest earned 2006: ($560,000 $270,000)/$20,000 2005: ($500,000 $234,000)/$16,000 Return on sales 2006: $180,000/$1,000,000 2005: $170,000/$860,000 Return on assets 2006: $180,000/$628,000 2005: $170,000/$566,000 Return on equity 2006: $180,000/$320,000 2005: $170,000/$300,000

2.

No, profitability declined slightly in 2006. Overall efficiency improved slightly; this is also reflected in the decrease in the average collection period, the decrease in the number of days sales in inventory, and the increase in the fixed asset turnover. Return on assets was down slightly. However, return on equity was maintained at approximately the same level because of an increase in leverage during the year. ANALYSIS: The book value of Urchs equity on December 31, 2006 is $320,000. Thus, at first glance, it might seem a bit expensive to pay $800,000 for the company. However, another way to view the valuation is that the price of $800,000 implies a price-earnings ratio of just 4.4 ($800,000 / $180,000) which is quite low. In fact, assuming a PE ratio of 20, the implied price for the company is $3,600,000 ($180,000 20). Thus, the $800,000 price for the company appears to be a bargain.

3.

P 3-27 Ratio Analysis 1. a. b. c. d. e. f. g. h. i. j. k. Ratios Current ratio Debt-to-equity ratio Debt ratio Asset turnover Average collection period Number of days sales in inventory Fixed asset turnover Times interest earned Return on sales Return on assets Return on equity 2006 1.36 0.63 38.6% 3.01 11.0 days 39.2 days 5.3 14.0 7.4% 22.2% 36.1% 2005 .80 0.60 37.5% 2.80 11.4 days 21.6 days 4.5 21.0 6.3% 17.5% 28.0%

Chapter 3 23

a. b. c. d. e. f. g. h. i. j. k. 2.

Calculations Current ratio Debt-to-equity ratio Debt ratio Asset turnover Average collection period Number of days sales in inventory Fixed asset turnover Times interest earned Return on sales Return on assets Return on equity

2006: $30,000/$22,000 2005: $20,000/$25,000 2006: $34,000/$54,000 2005: $30,000/$50,000 2006: $34,000/$88,000 2005: $30,000/$80,000 2006: $265,000/$88,000 2005: $224,000/$80,000 2006: $8,000/($265,000/365) 2005: $7,000/($224,000/365) 2006: $20,000/($186,000/365) 2005: $10,000/($169,000/365) 2006: $265,000/$50,000 2005: $224,000/$50,000 2006: $28,000/$2,000 2005: $21,000/$1,000 2006: $19,500/$265,000 2005: $14,000/$224,000 2006: $19,500/$88,000 2005: $14,000/$80,000 2006: $19,500/$54,000 2005: $14,000/$50,000

There is improvement. Many of the ratios have improved from 2005 to 2006. In particular, both profitability and efficiency increased from 2005 to 2006, combining to increase overall return on assets. An exception to this efficiency trend is the increase in the number of days sales in inventory. There may be some concern about the increasing amount of leverage. However, the level of debt still appears to be low. ANALYSIS: A new loan of $84,000 would increase Maas Corporations debt ratio from 38.6% at the end of 2006 to 68.6%. This new debt ratio is computed as follows: Debt ratio = Total liabilities / Total assets Debt ratio = ($34,000 + $84,000) / ($88,000 + $84,000) Debt ratio = 68.6% This large increase in debt ratio indicates an increased likelihood that Maas will be unable to satisfy all of its obligations. However, another way to view the level of debt is to see whether Maas will be able to make its interest payments. If it is assumed that the interest rate on the new loan is 10% and that the new assets will not increase operating income at all, the times interest earned ratio for Maas will decrease from 14.0 to 2.7, computed as follows: Times interest earned = Operating income / Interest expense Times interest earned = $28,000 / ($2,000 + $8,400) Times interest earned = 2.7 This computation assumes that the new assets, which almost double the total assets of Maas, would not increase operating income at all. If operating income were doubled to match the increase in assets, then the times interest earned value would be over 5. Thus, it appears that Maas will still be able to make its interest payments, even with such a large increase in debt ratio. It makes sense to recommend to Lorien Bank that the loan be made.
Chapter 3 24

3.

P 3-28 Analysis of Financial Statements 1. R.J.P. Company Balance Sheet December 31, 2006 Assets Cash 25,000 Accounts receivable 20,0001 Total current assets 45,000 Property, plant, and equipment 22,50011 Total assets 67,500
10

Liabilities and Stockholders Equity $ Accounts payable $ $ 37,5002 Long-term liabilities 08 Total liabilities $ $ 37,5007 Total stockholders equity 30,0006 Total liabilities and stockholders equity $ 67,5009 R.J.P. Company Income Statement For the Year Ended December 31, 2006

Revenues Sales Expenses Cost of goods sold Selling expense General and administrative expense Interest expense Taxes Total expenses Net income $35,000 20,000 6,000 900 1,100

$70,0003

63,0004 $ 7,0005

Chapter 3 25

This problem is best solved in the following order (the proper identifying letters are shown along with the superscripted numbers): a: d: i: j: k: g: f: e: h: c: b:
1 2 3 4 5

6 7 8

9 10 11

$20,000 = $45,000 $25,000 (accounts receivable) $37,500 = $45,000/1.2 (accounts payable) $70,000 = $35,000/0.50 (revenues) $63,000 = $35,000 + $20,000 + $6,000 + $900 + $1,100 (total of all expenses) $7,000 = $70,000 0.10 (net income) or $7,000 = $70,000 $63,000 $30,000 = $7,000/0.2333 (stockholders equity) $37,500 = $30,000 1.25 (total liabilities) Since the accounts payable is $37,500 and total liabilities are $37,500, longterm liabilities must be $0. (long-term liabilities) $67,500 = $37,500 + $30,000 (total liabilities and stockholders equity) Total assets = Total liabilities + stockholders equity (see h above) $22,500 = $67,500 $45,000 (property, plant, and equipment)

Chapter 3 26

2.

ANALYSIS: The average collection period for R.J.P. Company for 2006 is 104.3 days, computed as follows: Average collection period = Accounts receivable / (Sales / 365) Average collection period = $20,000 / ($70,000 / 365) Average collection period = 104.3 days If R.J.P. Company can lower its average collection period to 60 days, the accounts receivable balance would drop to $11,507, computed as follows: Average collection period = Accounts receivable / (Sales / 365) 60 days = Accounts receivable / ($70,000 / 365) Accounts receivable = $11,507 The fixed asset turnover for R.J.P. Company for 2006 is 3.1, computed as follows: Fixed asset turnover = Sales / Fixed assets Fixed asset turnover = $70,000 / $22,500 Fixed asset turnover = 3.1 If R.J.P. Company can increase its fixed asset turnover to 4.0, the property, plant, and equipment balance would drop to $17,500, computed as follows: Fixed asset turnover = Sales / Fixed assets 4.0 = $70,000 / Fixed assets Fixed assets = $17,500 The total drop in assets resulting from these two increases in efficiency is $13,493 [($20,000 + $22,500) ($11,507 + $17,500)]. Since it is assumed that any funds freed up from the asset reductions would be returned to the stockholders, R.J.P. Companys equity would decrease from $30,000 to $16,507 ($30,000 $13,493). R.J.P. Companys return on equity would increase from 23.33% to 42.4% ($7,000 / $16,507).

P 3-29 Cash Flow Analysis 1. a. b. c. d. e. f. 2. Return on sales Return on assets Return on equity Cash flow to net income ratio Cash flow adequacy ratio Cash times interest earned ratio 2006 8.2% 8.6% 32.7% 1.33 0.84 10.1 2005 6.5% 6.9% 24.0% 2.71 1.91 16.5

According to the traditional accrual accounting measures, Doyle performed better in 2006return on sales, assets, and equity are all higher in 2006 than in 2005. However, using the cash flow ratios, Doyle performed better in 2005. From an operating cash flow perspective, Doyles performance deteriorated significantly in 2006.

Chapter 3 27

3.

ANALYSIS: When companies are preparing to issue stock or apply for new loans, they have an incentive to bias the financial statements to look as good as possible. One way to detect this bias is to examine the relationship between net income, which can be influenced by accrual accounting assumptions, and cash from operating activities, which is not affected by accrual accounting assumptions. It appears that Doyles net income increased in 2006 even while cash from operating activities was decreasing. It is important that Doyle be able to explain this divergence to potential investors.

APPLICATIONS AND EXTENSIONS SOLUTIONS

Deciphering Actual Financial Statements Deciphering 3-1 (McDonalds) 1. Sales by Company-operated restaurants Operating costs and expenses for Company-operated restaurants: Food and paper Payroll and other employee benefits Occupancy and other operating expenses Total operating costs and expenses Operating income from Company-operated restaurants 2. Sales by Company-operated restaurants Operating costs and expenses for Company-operated restaurants: Food and paper Payroll and other employee benefits Occupancy and other operating expenses Total operating costs and expenses Operating income from Company-operated restaurants 3. 2003 $12,795.4 2002 $11,499.6 2001 $11,040.7

4,314.8 3,411.4 3,279.8 11,006.0 $ 1,789.4 2003 100.0%

3,917.4 3,078.2 2,911.0 9,906.6 $1,593.0 2002 100.0%

3,802.1 2,901.2 2,750.4 9,453.7 $1,587.0 2001 100.0%

33.7 26.7 25.6 86.0 14.0

34.1 26.8 25.3 86.1 13.9

34.4 26.3 24.9 85.6 14.4

The common-size income statements for McDonalds Company-owned stores reveal that McDonalds cost structure is surprisingly consistent from one year to the next. The percentages never vary more than a percentage point. However, there is a disturbing decrease in operating profitability from 2001 to 2002, which was partially offset by an increase in operating profitability from 2002 to 2003. In addition, we can learn the secret of what the food and paper cost is for a $2.00 Big Mac68 cents ($2.00 0.34).

Chapter 3 28

4. Total McDonalds operating income Operating income from Company-operated restaurants Difference

2003 $2,832.2 1,789.4 $1,042.8

2002 $2,112.9 1,593.0 $ 519.9

2001 $2,697.0 1,587.0 $1,110.0

This preliminary calculation suggests that McDonalds gets more than half of its operating income from Company-owned stores and less than half from franchise operations. However, this calculation assumes that ALL the general, administrative, and selling expenses are allocated to franchise operations, which is clearly not appropriate; some of these expenses should be allocated to Company-owned stores, reducing operating income from Company-owned stores and increasing operating income from franchise operations. Therefore, it appears that franchise operations might generate more operating income than do Company-owned stores. Deciphering 3-2 (DuPont) 1. Agriculture & Nutrition Coatings & Electronic & Performance Color Communication Materials Technologies Technologies $5,503 477 3,641 8.7% 1.51 13.1% Safety & Protection $4,071 536 2,527 13.2% 1.61 21.2% $2,892 147 2,408 5.1% 1.20 6.1% Textiles & Interiors $6,937 (1,336) 4,923 (19.3)% 1.41 (27.1)% $5,376 262 3,806 4.9% 1.41 6.9% Other $19 (150) 135 (789.5)% 0.14 (111.1)%

Total Sales $5,470 After-tax Operating Income(Loss) 540 Segment Assets at 12/31/03 6,508 Return on sales 9.9% Asset turnover 0.84 Return on assets 8.3% Pharmaceuticals Total Sales $ -0After-tax Operating Income(Loss)) 355 Segment Assets at 12/31/03 140 Return on sales N/A Asset turnover 0.00 Return on assets 253.6%

The Safety & Protection segment has the highest return on sales (13.17%) and the Other segments have the most negative return on sales. 2. 3. The Safety & Protection segment has the highest asset turnover (1.61) and the Pharmaceuticals segment has the lowest (0.00). The Pharmaceuticals segment has the highest return on assets (253.57%) and the Other segments have the most negative return on assets.

Chapter 3 29

Deciphering 3-3 (The Walt Disney Company) Media Parks and Networks Resorts Sales Operating Income Identifiable Assets Return on sales Asset turnover Return on assets 10,941 1,213 25,883 11.1% 0.42 4.7% United States Sales Operating Income/(loss) Identifiable Assets Return on sales Asset turnover Return on assets 1. 2. 3. 4. 5. 6. 7. 22,124 2,113 47,177 9.6% 0.47 4.5% 6,412 957 11,067 14.9% 0.58 8.6% Europe 3,171 591 2,200 18.6% 1.44 26.9%

Studio Entertainment 7,364 620 7,832 8.4% 0.94 7.9% Asia Pacific 1,331 518 484 38.9% 2.75 107.0%

Consumer Products 2,344 384 966 16.4% 2.43 39.8% Other 435 (48) 127 (11.0)% 3.43 (37.8)%

Return on sales: The Consumer Products segment has the highest return on sales. Asset turnover: The Consumer Products segment has the highest asset turnover. Return on assets: The Consumer Products segment has the highest return on assets. Return on sales: The Asia Pacific area has the highest return on sales. Asset turnover: The Other areas have the highest asset turnover. Return on assets: The Asia Pacific area has the highest return on assets. Return on equity cannot be computed for each business segment or for each geographic area because it is not possible to assign long-term corporate debt and stockholders equity to the individual segments or areas. Frequently, financing activities are undertaken at the general corporate level, so it isnt possible for external users to determine how much leverage is associated with each individual segment.

Chapter 3 30

Deciphering 3-4 (Coke vs. Pepsi) 1. Overall Net income Total equity Return on equity Net income Sales Return on sales Sales Total assets Asset turnover Total assets Total equity Assets-to-equity ratio 2. Beverage Segment Net income Sales Return on sales Sales Total assets Asset turnover Net income Total assets Return on assets 3.

PepsiCo $3,568 $11,896 30.0% $3,568 $26,971 13.2% $26,971 $25,327 1.06 $25,327 $11,896 2.13 PepsiCo $1,775 $7,733 23.0% $7,733 $5,856 1.32 $1,775 $5,856 30.3%

Coca-Cola $4,347 $14,090 30.9% $4,347 $21,044 20.7% $21,044 $27,342 0.77 $27,342 $14,090 1.94

The DuPont analysis in (1) suggests that Coca Cola and PepsiCo are roughly equal with respect to return on equity. The slight difference is due to Coca Colas higher profitability as measured by return on sales, even though PepsiCo has a higher asset turnover and a higher assets-to-equity ratio. The PepsiCo Beverage segment data reveal that the slight difference between PepsiCos and Coca Colas return on equity is partially attributable to PepsiCos non-beverage operations. PepsiCos Beverage-only return on sales is greater than that of Coca Cola.

Chapter 3 31

International Financial Statements: Which Is the Stronger Partner in the Merger? 1. On December 31, 1997, the exchange rate between Deutsche marks and U.S. dollars was DM 1.7912 = U.S.$1. This rate can be found by using any one of many historical exchange rate databases on the Internet. Using this exchange rate to convert Daimler-Benzs automotive sales into U.S. dollars yields the following comparison: Daimler-Benz Automotive Sales DM 91,632 Currency adjustment U.S. dollar sales in 1997 $58,662 1.7912 $51,157 Chrysler Automotive ______ $58,662

So, Chrysler had more worldwide automotive sales in 1997. 2. Overall a. Return on sales: Daimler-Benz DM 8,042 61,147 6.5% Daimler-Benz $61,147 137,099 0.90 Daimler-Benz DM 8,042 137,099 5.9% Chrysler $ 2,805 4.6% Chrysler 60,418 1.01 Chrysler $ 2,805 60,418 4.6%

Net income Sales 124,050 Return on sales b. Asset turnover:

Sales DM 124,050 Total assets Asset turnover c. Return on assets:

Net income Total assets Return on assets Automotive a. Return on sales: Net income Sales 91,632 Return on sales b. Asset turnover:

Daimler-Benz DM 3,501 58,662 3.8% Daimler-Benz $58,662 46,955 1.95 Daimler-Benz DM 3,501 46,955 7.5%

Chrysler $ 4,238 7.2% Chrysler 44,483 1.32 Chrysler $ 4,238 44,483 9.5%

Sales DM 91,632 Total assets Asset turnover c. Return on assets:

Net income Total assets Return on assets

Chapter 3 32

3.

The ratios computed in (2) show relationships between certain financial statement amounts. Those relationships are the same whether the numbers are stated in marks, dollars, yen, or kwatloos. As long as both the numbers used in computing a financial ratio are stated in the same currency, no exchange adjustments need to be made when computing the ratio.

Business Memo: Who Should Get a Holiday Loan? MEMO To: Loan Committee Subject: Loans to Fun Toy Company and The Toy Store The Fun Toy Company appears to be a good candidate for the receipt of a loan. It currently has a relatively low level of leverage, as evidenced by its debt ratio of 41.5%. Fun Toys return on equity is a respectable 18.8%return on equity would be higher if Fun Toy had more leverage. However, a cause for concern is the note payable due in October 2006, which is now classified as a current liability because the balance sheet date is September 30, 2006. If the new loan is made, the Fun Toy Company will have two large repayments in a relatively short period of time. Perhaps the term of the new loan should be lengthened or installments should be paid monthly. Fun Toy Company Selected Ratio Values Return on sales Asset turnover Return on assets Return on equity Current ratio Debt ratio 7.5% 1.46 11.0% 18.8% 1.50 41.5%

The Toy Store already has a great deal of debt as evidenced by its 64.3% debt ratio. Toy Stores current ratio is also quite low. These two ratio values indicate that Toy Store does not have a large financial cushion. On the positive side, Toy Store is currently generating a return on equity of 20% (thanks in part to its high leverage). A loan to Toy Store would be more risky than a loan to Fun Toy. Toy Store Selected Ratio Values Return on sales Asset turnover Return on assets Return on equity Current ratio Debt ratio 5% 1.43 7.1% 20.0% 1.15 64.3%

Research: Finding Sources for Industry Ratios. The ratio source used to develop this solution is: Leo Troy, Almanac of Business and Industrial Financial Ratios: 1996 Edition , Prentice Hall, Englewood Cliffs, NJ, 1996. 1. The sample used in this ratio source is the 3.9 million corporate federal tax returns filed with the Internal Revenue Service. This is a much larger sample than those used for most industry ratio surveys.

Chapter 3 33

2.

The industry groups are defined using the IRS industry classifications. These classifications closely follow the widely used SIC (Standard Industrial Classification). Within industry, firms are separated into 13 size classes, with all companies having more than $250 million in assets being grouped in the largest size class. Some of the ratio definitions used are: Total liabilities to net worth: This is the same as the debt-to-equity ratio defined in the textbook. Coverage ratio: This ratio is the same as the times interest earned ratio defined in the textbook. Three industries and their return on sales are as follows: Grocery stores............................................................................ Accounting, auditing, and bookkeeping services....................... Drugs (pharmaceuticals)............................................................ 0.7% 6.3% 12.8%

3.

4.

Ethics Dilemma: Does the Bonus Plan Reward the Right Thing? The underlying problem here is that the bonus plan rewards the wrong thing. Investors care about the overall return on their investment, and one measure of this is return on equity. Return on sales is only one component of return on equity but, because of the bonus plan, this is the component that management is focusing on. The real solution to this problem is to redesign the bonus plan to reward managers based on return on equity, not return on sales. But the redesigning of the bonus plan is not going to happen within the next two weeks, so what do you do in the meantime? You must present your findings to the chief financial officer. The last thing you should do is keep your boss in the dark about your findings. It would be embarrassing for top management if this proposal were to go forward to the board of directors as a great plan to increase return on sales, only to have one of the board members ask about the impact of the machine acquisition on total return on equity. Top managers have two weeks to decide what they should do; your responsibility is to present your findings to your boss now to give the top managers time to reevaluate the project. At the same time that you present your return on equity calculations to the chief financial officer, you would also do well to offer some alternative plans of action. In this case, one alternative is to finance the machine acquisition with debt instead of with stockholder investment. The increased interest expense will hurt return on sales (and management bonuses), but the increased leverage may boost return on equity enough to make the project worthwhile. The Debate Numbers The value of a company to investors and its attractiveness to creditors is summarized in the ability of the company to generate cash flow in the future. The power of historical financial statements is in their ability to aid the prediction of future cash flows. The financial statements summarize all of the complex factors impacting the performance of a company. The non-quantitative factors that impact a company are only of interest to the extent that they influence the cash flows that the company can generate.

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People One prominent banker reported the following when asked about the most important factors to consider in making a loan: Third most importantthe financial statements. Second most importantthe quality of the collateral backing the loan. Most importantthe character of the management. Unethical or unreliable managers create a much greater uncertainty to a lender about whether a loan will be repaid. Reliable managers will find a way to repay a loan, even when they could escape the obligation through legal maneuvering. Cumulative Spreadsheet Project 1 a. Year 2006 BALANCE SHEET Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities 10 27 153 190 199 9 380 74 10.6% 10 84 12.0% Long-term debt Total liabilities 207 291 29.6% 41.6% Stockholders Equity Paid-in capital Retained earnings (as of 12/31/06) Total liab. and equities Retained earnings (as of 1/1/06) + Net income Dividends Retained earnings (as of 12/31/06) 50 39 380 31 8 0 39 7.1% 5.6% 54.3% 1.4% 1.4% 3.9% 21.9% 27.1% 28.4% 1.3% 54.3%

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INCOME STATEMENT Sales Cost of goods sold Gross profit Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income b. Current ratio Debt ratio Asset turnover Return on sales Return on equity Average collection period Number of days sales in inventory Times interest earned 2. a.

700 519 181 160 21 9 12 4 8 2.26 76.6% 1.84 1.1% 9.0% 14.1 107.6 2.33 Year 2006

100.0% 74.1% 25.9% 22.9% 3.0% 1.3% 1.7% 0.6% 1.1%

BALANCE SHEET Assets Cash Receivables Inventory Total current assets Property, plant, & equipment Accumulated depreciation Total assets Liabilities Accounts payable Short-term loans payable Total current liabilities Long-term debt Total liabilities Stockholders Equity Paid-in capital Retained earnings (as of 12/31/06) Total liab. and equities

10 27 153 190 199 9 380 74 16 90 207 297 50 33 380

1.4% 3.7% 21.0% 26.0% 27.3% 1.2% 52.1% 10.1% Increase 2.2% fro Increase from $10 to $16 to balance. 12.3% 28.4% 40.7% 6.8% 4.5% 52.1%

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Retained earnings (as of 1/1/06) + Net income Dividends Retained earnings (as of 12/31/06) INCOME STATEMENT Sales Cost of goods sold Gross profit Other operating expenses Operating income Interest expense Income before taxes Income tax expense Net income b. Current ratio Debt ratio Asset turnover Return on sales Return on equity Average collection period Number of days sales in inventory Times interest earned 3.

31 2 0 33

730 550 180 165 15 9 6 4 2 2.11 78.2% 1.92 0.3% 2.4% 13.5 101.5 1.67

100.0% Increase froIIncrease from $700 to $730. 75.3% Increase froIIncrease from $519 to $550. 24.7% 22.6% Increase froIIncrease from $160 to $165. 2.1% 0.8% 0.5% 0.3%

The impact of the changes in part (2) is to make Handyman a less profitable company. This is reflected in the lower return on sales and lower return on equity in part (2). The other changes in the ratios and in the common-size financial statements are relatively minor. Thus, the financial statements in part (1) represent a stronger company.

Internet Search The information for this Internet solution was obtained on April 16, 2004. 1. The current chief executive officer (CEO) of DuPont is Charles O. (Chad) Holliday, Jr., 55. Mr. Holliday has been with DuPont for 34 years. He has been chief executive officer since February 1, 1998, and chairman since January 1, 1999. He is a graduate of the University of Tennessee where he received his bachelors degree in Industrial Engineering. At year-end 2003, DuPont employed about 81,000 people. Approximately one-third of the companys employees work outside the United States. DuPont operates in approximately 70 countries worldwide, with more than 75 research and development labs worldwide. In 2003, more than half of the companys sales were outside the United States. DuPonts polymer chemists invented nylon in 1938. Kevlar is used for, among other things, bulletproof vests, brake and transmission parts, and automobile belts and hoses. DuPont reports that it has reduced its air carcinogenic emissions by 92% since 1987.

2.

3. 4.

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You Be the Analyst! Comparing DuPont to Its Peers The data for this solution were gathered on June 4, 2004. Of course, solutions will differ depending on when this exercise is completed. 1. For the year ended December 31, 2003, DuPonts net profit margin was 3.60%. For the same year, the mean net profit margin for DuPonts industry group was 2.58%. The company with the highest net profit margin was Reliance Industries Limited (based in Mumbai, India) with a net profit margin of 8.81%. 2. For the year ended December 31, 2003, DuPonts total asset turnover was 0.75. For the same year, the mean total asset turnover for DuPonts industry group was 0.87. The company with the highest total asset turnover was Akzo Nobel (based in the Netherlands) with total asset turnover of 1.17. 3. For the year ended December 31, 2003, DuPonts financial leverage measure was 2.47. For the same year, the mean financial leverage measure for DuPonts industry group was 1.85. The company with the highest financial leverage measure was DuPont itself. 4. 3.60% 0.75 2.47 = 6.67%. This differs from the reported return on equity in Thomson One for Dupont of 10.09%. 5. As of December 31, 2003, the amount of DuPonts common equity was $9.544 billion. For the year ended December 31, 2003, reported net income before preferred stock dividends was $0.973 billion. Preferred dividends were $0.010 billion, so net income less preferred stock dividends was $0.963 billion. These numbers yield a return on equity of 10.09% ($0.963 billion / $9.544 billion) which exactly matches the return on equity reported in the Thomson One DuPont analysis but which does not match the product of profit margin, asset turnover, and financial leverage as reported in the Thomson One DuPont analysis. 6. As of December 31, 2003, DuPonts total assets were $35.985 billion. Total equity was $10.278 billion ($0.497 billion minority interest + $0.237 preferred stock + $9.544 common equity). The value for (total assets / total equity) is 3.50 ($35.985 billion / $10.278 billion) which is substantially more than the 2.47 found in (3). 7. As of December 31, 2003, DuPonts total assets were $35.985 billion. Total equity was $10.278 billion ($0.497 billion minority interest + $0.237 preferred stock + $9.544 common equity). Total long-term debt was $4.301 billion. The sum of total equity and long-term debt was $14.579 billion ($10.278 billion + $4.301 billion). The value for [total assets / (total equity + long-term debt)] is 2.47 ($35.985 billion / $14.579 billion) which matches the number found in (3). What we learn here is that different users of financial statements compute various ratios in different ways. The definitions shown in the textbook are common ones, but others are sometimes used. Accordingly, be careful to determine how each reported financial ratio was computed before you place too much reliance on it. Test Your Intuition You have probably heard of Just-In-Time inventory systems. What would a just-in-time system do to a companys number of days sales in inventory? The objective of a Just-In-Time inventory system is to reduce the level of inventory as far as possible. Reduced inventory means a lower number of days sales in inventory. Company Z has an asset to equity ratio of 2.5. What is its debt ratio? Its debt-to-equity ratio?

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With an assets-to-equity ratio of 2.5, Company Z has the following simplified balance sheet: Assets Liabilities Equities 2.5 1.5 1.0

Assets-to-equity ratio: 2.5 1.0 = 2.5 Debt ratio: 1.5 2.5 = 0.60 Debt-to-equity ratio: 1.5 1.0 = 1.5 It is always true (prove it to yourself using algebra) that the debt-to-equity ratio is equal to the assets-toequity ratio minus one. Business Context 3.1 Market Efficiency: Can Financial Statement Analysis Help You Win in the Stock Market? An attractive scenario for accountants would be the following. Upon the release of financial statement data to the public, stock prices move quickly and significantly to reflect the information contained in the financial statements. The significant reaction would indicate that the financial statements contained useful information that had not yet been available to investors from any other source. The quick reaction would suggest that information contained in the financial statements was obtained and incorporated by investors. If the public release of accounting data were to result in no price movement, that would seem to indicate that the financial statements contained no new information; investors had already learned everything from alternate sources of information such as sales forecasts, press releases, and so forth. This would call into question whether financial statements are a useful and timely source of information. A delay in the assimilation of the accounting data would be suggested if there was no immediate price reaction to the public release of the financial statements but there was a subsequent reaction over an extended period. This scenario might call into question the extent of the dissemination and the understandability of the financial statements. Data Mining 3.1: Margin and Turnover Company (industry) Disney (entertainment) Home Depot (home handyman) McDonalds (fast food) Safeway (supermarket) Wal-Mart (discount retailer) 1. 2. 3. 4. Margin 4.7% 6.6% 8.6% (0.5)% 3.5% Turnover 0.54 1.88 0.67 2.35 2.44 Return on Assets 2.5% 12.5% 5.8% (1.1)% 8.6%

McDonalds has the highest margin (8.6%). Wal-Mart has the highest turnover (2.44). Home Depot has the highest return on assets (12.5%). In general, the higher a companys margin the lower its turnover.

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5.

A company can generate a good return on assets by concentrating on either margin or turnover. For example, Home Depot, which concentrates on high turnover, earns a return on assets that is greater than that for McDonalds which has low turnover but higher margin. Low margin industries are those in which price competition is high. High margin industries are those in which product differentiation allows for higher prices. The key is to properly combine margin and turnover, given the constraints of your industry, to maximize the return on assets. Affordable Interest Rate 7.0% 6.5% 46.4% 10.2% 19.7%

Data Mining 3.2: Identifying LBO Targets Company Intel Microsoft AT&T Dow Chemical Safeway Cash Flow Available $13,082 18,597 7,329 4,022 1,972 Amount Borrowed $187,712 284,432 15,791 39,427 10,000

In the table above, the cash flow available is the sum of the cash from operations and the cash paid for taxes. The amount borrowed is the market value of the equity of the buyout target. The affordable interest rate is the interest rate on the debt received to finance the buyout that could be paid using the available cash flow currently being generated by the buyout target. Thus, in the case of Intel, the cash from operations plus the cash paid for taxes would be enough to allow for payment of 7.0% interest on the $187.712 billion that would need to be borrowed to finance a 100%-debt acquisition. The worst buyout target is Microsoft. Microsofts cash flow is only sufficient to pay 6.5% interest on the amount that would need to be borrowed to buy Microsoft. It is highly unlikely that one could find lenders willing to accept such a low interest rate. The best buyout target is AT&Tthe cash flow generated by AT&T is sufficient to be able to pay 46.4% interest on any borrowing needed to finance the acquisition. Web Search Most large companies maintain an archive of recent press releases in the Investor Relations segment of their Web site. Access DuPonts Web site at http://www.dupont.com and identify the most significant announcement in the most recent three months. As of April 16, 2004, the most significant DuPont news release in the preceding three months was as follows: April 12, 2004 DuPont today announced that it will reduce its global employee work force, excluding INVISTA, by 6 percent, or 3,500 positions, as part of its $900 million cost improvement program announced on Dec. 1, 2003. In addition, the company is reducing 450 contractor positions. During the period Dec. 1, 2003, to Dec. 31, 2004, the company expects to eliminate about 3,000 positions through severance programs and about 500 positions through normal attrition. The impact will be primarily in North America and Western Europe. These actions do not include the company's INVISTA subsidiary. The work force reductions are among actions DuPont is taking to achieve a $900 million annualized cost improvement in 2005. The company said it is on track to realize that objective through fixed and variable cost reductions, as well as variable margin improvements.

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