Analyzing and Interpreting Financial Statements: Learning Objectives - Coverage by Question

Chapter 5
Analyzing and Interpreting Financial

Statements
Learning Objectives coverage by question
MiniExercises
LO1 Prepare and analyze common
size financial statements.
LO2 Compute and interpret
measures of return on investment,
including return on equity (ROE),
return on assets (ROA), and return on
financial leverage (ROFL).
LO3 Disaggregate ROA into
profitability (profit margin) and
efficiency (asset turnover)
components.
LO4 Compute and interpret
measures of liquidity and solvency.
15, 16,
19, 20
14, 17,
21, 22, 24
Exercises
Cases and
Projects
35
36, 38,
25 - 31, 34
41, 45
14, 17,
25, 27 - 31,
36, 38,
21, 22, 24
34
41, 46, 47
18, 23
32, 33
37, 39, 42
LO5 Appendix 5A: Measure and

analyze the effect of operating
activities on ROE.
LO6 Appendix 5B: Prepare pro
forma financial statements.
Problems
50
48 - 50
50
40, 43
35
44
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 5
5-1
DISCUSSION QUESTIONS
Q5-1.
Return on investment measures profitability in relation to the amount of

investment that has been made in the business. A company can always
increase dollar profit by increasing the amount of investment (assuming it is a
profitable investment). So, dollar profits are not necessarily a meaningful way to
look at financial performance. Using return on investment in our analysis,
whether as investors or business managers, requires us to focus not only on
the income statement, but also on the balance sheet.
Q5-2.
ROE is the sum of return on assets (ROA) and the return that results from the
effective use of financial leverage (ROFL). Increasing leverage increases ROE
as long as ROA exceeds the after-tax interest rate. Financial leverage is also
related to risk: the risk of potential bankruptcy and the risk of increased
variability of profits. Companies must, therefore, balance the positive effects of
financial leverage against their potential negative consequences. It is for this
reason that we do not witness companies entirely financed with debt.
Q5-3.
Gross profit margins can decline because 1) the industry has become more
competitive, and/or the firms products have lost their competitive advantage so
that the company has had to reduce prices or is selling fewer units or 2) product
costs have increased, or 3) the sales mix has changed from highermargin/slowly-turning products to lower-margin/higher-turning products.
Declining gross profit margins are usually viewed negatively. On the other
hand, cost increases that reflect broader economic events or certain strategic
product mix changes might not be viewed negatively.
Q5-4.
Reducing advertising or R&D expenditures can increase current operating profit

at the expense of the long-term competitive position of the firm. Expenditures
on advertising or R&D are more asset-like and create long-term economic
benefits.
Q5-5.
Asset turnover measures the amount of revenue volume compared with the
investment in an asset. Generally speaking, we want turnover to be higher
rather than lower. Turnover measures productivity and an important company
objective is to make assets as productive as possible. Since turnover is one of
the components of ROE (via ROA), increasing turnover increases shareholder
value. Turnover is, therefore, viewed as a value driver.
Q5-6.
ROE>ROA implies a positive return on financial leverage. This results from

borrowed funds being invested in operating assets whose return (ROA)
exceeds the cost of borrowing. In this case, borrowing money increases ROE.
Q5-7.
Common-size financial statements express balance sheet and income

statement items in ratio form. Common-size balance sheets express each
asset, liability and equity item as a percentage of total assets and common-size
income statements express each line item as a percentage of sales. The ratio
form facilitates comparison among firms of different sizes as well as across
time for the same firm.

5-2
Financial Accounting, 4th Edition
Q5-8.
The asset turnover ratio (AT) is the ratio of sales revenue to average total
assets. The ratio is increased by increasing sales while holding assets
constant, or by reducing assets without reducing sales. The most effective
means of improving the ratio is to increase the efficient utilization of operating
assets. This is done by improving inventory management practices, improving
accounts receivable collection, and improving the efficient use of PP&E.
Q5-9.
The net in net operating assets, means operating assets net of operating
liabilities. This netting recognizes that a portion of the costs of operating assets
is paid for by parties other than the company. For example, payables and
accrued expenses help fund inventories, wages, utilities, and other operating
costs. Similarly, long-term operating liabilities also help fund the cost of longterm operating assets. Thus, these long-term operating liabilities are deducted
from long-term operating assets.
Q5-10. Companies must manage both the income statement and the balance sheet in
order to maximize ROA. This is important, as many managers look only to the
income statement and do not fully appreciate the value added by effective
balance sheet management. The disaggregation of ROA into its profit margin
and turnover components facilitates analysis of these two areas of focus.
Q5-11. There are an infinite number of possible combinations of margin and turnover
that will yield a given level of ROA. The relative weighting of profit margin and
asset turnover is driven in large part by the companys business model. As a
result, since companies in an industry tend to adopt similar business models,
industries will generally trend toward points along the margin/turnover
continuum.
Q5-12. Liquidity refers to how much cash a company has, how much cash is coming in,
and how much cash can be raised quickly. Companies must generate cash in
order to pay their debts, pay their employees and provide their shareholders a
return on investment. Cash is, therefore, critical to a companys survival.
Q5-13. Ratio analysis relies on the data presented in the financial statements and is,
therefore, dependent on the quality of those statements. Differences in the
application of GAAP across companies or within the same company across
time can affect the reliability of the analysis. Limitations of GAAP itself and
differences in the make-up of the company (e.g., types of products or industries
in which the company competes) can also affect the usefulness of ratio
analysis.

5-3
MINI EXERCISES
M5-14. (15 minutes)
a. ROE = $5,000/$500,000 = 1%
ROA = $20,000/$1,000,000 = 2%
ROFL = 1% - 2% = -1%
b. Net profit margin = $5,000/$1,000,000 = 0.5%
Asset turnover = $1,000,000/$1,000,000 = 1.0
Financial leverage = $1,000,000/$500,000 = 2.0
c. ROFL is negative for Sunder Company, indicating that financial leverage is hurting
this company. The return on assets is insufficient to cover the interest cost of the
debt. DuPont analysis masks this problem. The financial leverage ratio of 2.0
suggests (incorrectly) that leverage doubled the return.
M5-15. (20 minutes)
TARGET CORPORATION
Common-size Balance Sheets
Cash and cash equivalents.
Accounts receivable, net.
Inventory.
Other current assets.
Total current assets..
Property and equipment, net..
Other noncurrent assets..
Total assets
2012
1.7%
12.7%
17.0%
3.9%
35.3%
62.5%
2.2%
100.0%
2011
3.9%
14.1%
17.4%
4.0%
39.4%
58.3%
2.3%
100.0%
Accounts payable.
Accrued liabilities..
Current portion of long-term debt and notes payable............
Total current liabilities.
Long-term debt..
Deferred income taxes.
Other noncurrent liabilities.
Total shareholders' investment.
Total liabilities and shareholders' investment..
14.7%
7.8%
8.1%
30.6%
29.4%
2.6%
3.5%
33.9%
100.0%
15.2%
7.6%
0.3%
23.0%
35.7%
2.1%
3.7%
35.4%
100.0%

5-4
M5-16 (20 minutes)

TARGET CORPORATION
Common-size Income Statement
Year ended:
January 28, 2012
Sales....
98.0%
Net credit card revenues..
2.0%
Total revenues
100.0%
Cost of sales
68.5%
Selling, general and administrative expenses
20.2%
Credit card expenses.
0.6%
Depreciation and amortization..
3.1%
Earnings before interest expense and income taxes
7.6%
Net interest expense..
1.2%
Earnings before income taxes..
6.4%
Provision for income taxes
2.2%
Net earnings
4.2%
M5-17. (15 minutes)

($ millions)
a. EWI = $2,929 + $869 x (1-.35) = $3,493.8
Average total assets = ($46,630 + $43,705)/2 = $45,167.5
ROA = $3,493.8/$45,167.5 = 7.74%
b. PM = $3,493.8/$69,865 = 5.00%
AT = $69,865 /$45,167.5= 1.547
5.00% X 1.547 = 7.74%
M5-18. (20 minutes)
a. 2012 current ratio = $16,449 / $14,827 = 1.15
2011 current ratio = $17,213 / $10,070 = 1.71
2012 quick ratio = ($794 + $5,927) / $14,827 = 0.47
2011 quick ratio = ($1,712 + $6,153 / $10,070 = 0.78
Both of these ratios declined over the year, as Targets cash balance dropped by
about $1 billion and its borrowings due within the year increased by more than $3.5
billion. Current ratio above 1 is good for a retailer and Targets quick ratio is about
average for a retailer. Target is fairly liquid, even with the declines in these ratios,
but it would be worthwhile to see whether these changes represent a trend.
continued next page
5-5
M5-18. concluded
b. 2012 times interest earned = ($4,456 + $869) / $869 = 6.12
2012 debt-to-equity = ($46,630 - $15,821) / $15,821= 1.95
2011debt-to-equity = ($43,705 - $15,487) / $15,487 = 1.82
Targets debt-to-equity increased slightly but is not at a particularly high level.
c. Target is liquid and not excessively financially leveraged. Its times interest earned
ratio indicates that earnings before interest and taxes is just over 6 times interest
expense. Because the company generates significant operating profits and cash
flow, we have no solvency concerns about Target.
M5-19. (20 minutes)
3M COMPANY
Common-size Balance Sheets
Cash and cash equivalent...
Accounts receivable.
Total inventories
Other current assets
Total current assets
Investments
Property, plant and equipment, net
Goodwill..
Intangible assets, net
Prepaid pension and postretirement benefits
Other assets..
Total assets
2011
11.7%
12.2%
10.8%
4.0%
38.7%
3.3%
24.3%
22.3%
6.1%
0.1%
5.2%
100.0%
2010
14.8%
12.0%
10.5%
3.2%
40.5%
2.3%
24.1%
22.6%
6.0%
0.3%
4.2%
100.0%
Short-term borrowings and current portion of long-term

debt.
Accounts payable..
Accrued payroll..
Accrued income taxes
Other current liabilities
Total current liabilities
Long-term debt
Other liabilities
Total liabilities
Stockholders' equity, net
Total liabilities and stockholders' equity
2.2%
5.2%
2.1%
1.1%
6.6%
17.2%
14.2%
18.4%
49.8%
50.2%
100.0%
4.2%
5.5%
2.6%
1.2%
6.7%
20.2%
13.9%
12.8%
46.9%
53.1%
100.0%

5-6
M5-20. (15 minutes)

3M COMPANY
Common-size Income Statements
Net sales.....
Operating expenses:
Cost of sales...
Selling general and administrative expenses
Research, development and related expenses.
Operating income..
Interest expense and income:
Interest expense.
Interest income
Total
Income before income taxes and minority interest
Provision for income taxes
Net income
2011
$29,611
100.0%
53.0%
20.8%
5.3%
20.9%
2010
$26,662
100.0%
51.9%
20.5%
5.4%
22.2%
0.6%
-0.1%
0.5%
20.4%
5.7%
14.7%
0.7%
-0.1%
0.6%
21.6%
6.0%
15.6%
M5-21. (20 minutes)

($ millions)
a. 2011 EWI = $4,357+ $186 x (1-.35) = $4,477.9
2011 Average total assets = ($31,616 + $30,156)/2 = $30,886
ROA = $4,477.9/$30,886 = 14.50%
b. PM = $4,477.9/$29,611 = 15.12%
AT = $29,611/($31,616 +$30,156)/2 = 0.959
15.12% X 0.959 = 14.50%

5-7
M5-22. (15 minutes)

($ millions)
a. URBN:
TJX:
b. URBN:
Average total assets = ($1,483.7 + $1,794.3)/2 = $1,639.0

ROA = $185.2/$1,639.0= 11.30%
Average total assets = ($8,281.6 + $7,971.8)/2 = $8,126.7
ROA = $1,526.5 /$8,126.7= 18.78%
PM = $185.2 / $2,473.8= 7.49%
AT = $2,473.8 / $1,639.0= 1.51
7.49% X 1.51 = 11.30%
TJX:
PM = $1,526.5 / $23,191.5 = 6.58%

AT = $23,191.5 /$8,126.7 = 2.85
6.58% X 2.85 = 18.78%
c. URBNs ROA is less than TJXs. TJX operates in the value-priced segment of its
industry which explains its lower PM. As is typical of value-priced retailers, TJXs
asset turnover is high its AT is almost double that of URBN. On balance, TJXs
business model appears to be more successful in 2011 as it is able to maintain both
a high AT and a reasonable PM, resulting in higher ROA.
M5-23. (20 minutes)
($ millions)
a. Verizons current ratio for the two years presented is as follows:
2011 current ratio: $30,939 / $30,761 = 1.01
2010 current ratio: $22,348 / $30,597 = 0.73
Liquidity is increasing and in 2011, Verizons current ratio nudged above 1.0. We
might want to know, however, whether Verizons current assets are concentrated in
cash or relatively illiquid inventories, as well as the maturity schedule of its current
liabilities. We would also like to know the median current ratio for the industry (1.41).
This would help place Verizons numbers in perspective.
continued next page

5-8
M5-23. concluded
b. Verizons times interest earned ratio for the two years is as follows:
2011 times interest earned = $13,310 / $2,827 = 4.71
2010 times interest earned = $15,207 / $2,523 = 6.03
Verizons times interest earned ratio has decreased, but remains significantly higher
than the industry median (3.12).
2011 debt-to-equity = $144,553 / $85,908 = 1.68
2010 debt-to-equity = $133,093 / $86,912 = 1.53
Verizons debt-to-equity ratio has increased, and is just slightly below the 1.76
median for companies in the telecommunications industry.
Verizons operating cash flow to current liabilities ratio is as follows:
2008 OCFCL = $29,780 / [($30,761 + $30,597)/2] = 0.97
c. Verizon is carrying a significant amount of debt. Although its profitability and
operating cash flow are fairly strong, neither is particularly high in relation to the
companys liabilities and interest costs. Verizons liquidity appears below that of
many others in its industry, and its debt-to-equity is now just below the median for
communications companies. There is some question, therefore, regarding the
amount of additional debt that the company can take on. Given its significant capital
expenditure requirements and its current debt load, Verizon may have to fund future
capital expenditures with higher-cost equity. And, to the extent that its competitors
are not as highly leveraged, this may negatively impact Verizons competitive
position.

5-9
M5-24. (30 minutes)

a.
$ millions
Asset Turnover
Procter & Gamble ..............................

$83,680/$135,299 = 0.62
McDonald's........................................
$27,006/$32,483 = 0.0.83
Valero Energy ...................................
$125,987/ $40,202 = 3.13
b.
$ millions
ART
Procter & Gamble ..............................

$83,680/$6,172 = 13.56
McDonald's........................................
$27,006/$1,257 = 21.48
Valero Energy ...................................
$125,987/ $6,645 = 18.96
$ millions
INVT
Procter & Gamble ..............................

$42,391/$7,050 = 6.01
McDonald's........................................
$6,167/$113 = 54.58
Valero Energy ...................................
$115,719/ $5,285 = 21.90
$ millions
PPET
Procter & Gamble ..............................

$83,680/$20,835 = 4.02
McDonald's........................................
$27,006/$22,448 = 1.20
Valero Energy ...................................
$125,987/ $23,923 = 5.27
c. For all three companies, these ratios reflect differences in their businesses, and the
overall AT ratio is related to the three individual ratios as seen in Exhibit 5.8 in the
chapter. Valero has the highes AT: it collects from its customers very quickly and
carries small amounts of inventory relative to its cost of goods sold. It also has the
lowest level of property, plant and equipment relative to its sales. Procter &
Gambles ratios are influenced by the relative strength of its largest customer (WalMart), resulting in higher inventory levels and slower collections. In addition, P&G
has a large level of intangible assets, as we will see in Chapter 8, so its PPET is
relatively high, but its AT is the lowest of the three. McDonalds inventory turnover is
very quick because of its perishable nature, and its receivable turnover is higher
because most customers pay in cash. The receivables result from the payments
due from franchisees.

5-10
EXERCISES
E5-25. (30 minutes)
a.
($ millions)
Target
[$2,929 + $869x(1-.35)] / $45,168 = 7.74%
Wal-Mart
[($16,387 + $2,322x(1-.35)] / $446,950 = 9.57%
b.
($ millions)
Target
Wal-Mart
PM = EWI / Sales
AT = Sales / Avg. Assets
[$2,929 + $869x x(1-.35)] / $69,865 =

5.00%
$69,865/$45,168
= 1.55
[($16,387 + $2,322x (1-.35)] / $446,950

= 4.00%
$446,950/$187,094
= 2.39
c. Wal-Marts ROA is greater than Targets in fiscal 2011. Wal-Marts value pricing
strategy is clearly evident in its lower PM, but this is more than offset by a higher
asset turnover and, hence, Wal-Marts business model is somewhat more
successful.
E5-26. (20 minutes)
a.
Case
Assets
Non-interest-bearing
liabilities
Interest-bearing liabilities
Shareholders equity
Earnings before interest
and taxes
Interest expense
Earnings before taxes
Tax expense (40%)
Net income
ROE
ROA
ROFL
A
1,000
B
1,000
C
1,000
D
1,000
E
1,000
F
1,000
0
0
1000
0
250
750
0
500
500
0
500
500
200
0
800
200
300
500
120
0
120
48
72
120
25
95
38
57
120
50
70
28
42
80
50
30
12
18
100
0
100
40
60
80
30
50
20
30
7.2%
7.2%
0.0%
7.6%
7.2%
0.4%
8.4%
7.2%
1.2%
3.6%
4.8%
-1.2%
7.5%
6.0%
1.5%
6.0%
4.8%
1.2%
continued next page

5-11
M5-26. concluded
b. These three cases differ only in the amount of interest-bearing liabilities used to
finance the firm. As leverage increases, the return to shareholders equity (ROE)
increases. However, the return on assets (ROA) does not change, because the
ROA is independent of the way that the business was financed.
c. However, financial leverage (the use of liabilities to finance the firm) does not always
work in favor of shareholders. The liability holders require a fixed return (6% aftertax = 10% x (1 40%)), and in order for leverage to work in favor of shareholders,
the overall return on assets must exceed this fixed return. In case C, the return on
assets is 7.2% > 6%, so ROFL is positive. In case D, the return on assets is 4.8% <
6%, so ROFL is negative.
In case E, the return on assets equals the after-tax return required on interestbearing liabilities, but the company has only non-interest-bearing liabilities. The
ROA is greater than zero, so ROFL is positive. In essence, the rate required on
liabilities is the break-even ROA in order for ROFL to be positive.
d. In case F, there is a mixture of liability types. Even though ROA is less than the
amount needed for interest-bearing liabilities, ROFL is positive because some of
company Fs liabilities require no interest.
The general relationship among these variables is the following:
ROE = ROA + ROA*(NL/SE) + [ROA (1 t)*i]*(IL/SE)
where
A = Assets,
NL = non-interest-bearing liabilities,
IL = interest-bearing liabilities,
SE = shareholders equity,
t = tax rate,
i = pre-tax interest rate on interest-bearing liabilities,
ROE = return on shareholders equity, and
ROA = return on assets.

5-12
E5-27. (20 minutes)

($ millions)
a.
CVS
Walgreen
$3,457+$588x(1-.35)=$3,839.2
$2,714+$89x(1-.35)=$2,771.9
($64,543 + $62,169)/2=$63,356.0
($27,454+$26,275 /2 = $36,864.5
$3,839.2/ $63,356.0 = 6.06%
$2771.9/ $26,864.5 = 10,32%
PM
$3,839.2/$107,100=3.58%
$2,771.9/$72,184=3.84%
AT
$107,100/$63,356.0=1.69
$72,184/$26,864.5 = 2.69
($38,051+$37,700)/2 = $37,875.5
($14,847+$14,400)/2 =$14,623.5
ROE
$3,457 / $37,875.5= 9.13%
$2,714 / $14,623.5 = 18.56%
ROFL
9.13% - 6.06% = 3.07%
18.56% - 10.32% = 8.24%
EWI
Avg. Assets
ROA
b.
c.
Avg. Equity
d. Walgreens ROE and ROA are higher than CVSs. CVSs PM is slightly lower than
Walgreens, but its AT is significantly lower. The low PMs for both companies reflect
the highly competitive retail pharmaceutical industry. Walgreens main advantage in
2011 lies in its use of financial leverage and its efficiency as reflected in its asset
turnover. However, the asset turnover differences would have to be examined
further, because Walgreens is (at the time of this writing) an active user of operating
leases that do not show up on its balance sheet. Chapter 10 looks at this important
topic.
E5-28. (30 minutes)
($ millions)
a. ROE
2011: $12,942 / [($45,911+$49,430) / 2] = 27.15%

2010: $11,464 / [($49,430+$41,704) / 2] = 25.16%
b. ROA
2011: [$12,942+$41x(1-.35)] / [($71,119+$63,186) / 2] = 19.31%

2010: [$11,464+$0x(1-.35)] / [($63,186+$53,095) / 2] = 19.72%
ROFL
2011: 27.15% - 19.31% = 7.84%

2010: 25.16% - 19.72% = 5.44%
continued next page

5-13
E5-28. concluded
c. Net Profit Margin 2011: $12,942 / $53,999= 23.97%
2010: $11,464 / $4.,623 = 26.28%
Asset Turnover
2011: $53,999 / [($71,119+$63,186) / 2] = 0.804

2010: $43,623 / [($63,186+$53,095) / 2] = 0.750
Financial
Leverage
2011: [($71,119+$63,186) / 2] / [($45,911+$49,430) / 2] = 1.41

2010: [($63,186+$53,095) / 2] / [($49,430+$41,704) / 2] = 1.28
Intels financial leverage increased from 2010 to 2011. Even though the companys
ROA dropped a bit from 2010 to 2011, the ROE went up due to the financial
leverage. Based on ROFL, leverage increased ROE by about 41% over ROA in
2011, versus a 28% increase in 2010. These increases correspond to the DuPont
financial leverage measure in this case because Intels borrowing costs are so low.
In general, there is a bias in DuPont analysis in that it tends to overstate the benefits
of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit
margin, which is lower than PM because the numerator is net of interest costs. For
comparison purposes, Intels PM ratios are presented below. In 2010, PM equals
the NPM because Intel reported no interest expense.
PM ratio
2011: [$12,942+$41x x(1-.35)] / $53,999 = 24.02%

2010: [$11,464+$0x (1-.35)] / $43,623 = 26.28%
E5-29. (30 minutes)

($ millions)
a. ROE
2011: $850 / [($138+$1,477) / 2] = 105.26%

2010: $805 / [($1,477+$2,184) / 2] = 43.98%
2009: $448 / [($2,184+$1,875) / 2] = 22.07%
b. ROA
2011: [$850+$246x(1-.35)] / [($6,108+$6,451) / 2] = 16.08%

2010: [$805+$208x(1-.35)] / [($6,451+$7,173) / 2] = 13.80%
2009: [$448+$237x(1-.35)] / [($7,173+$6,972) / 2] = 8.51%
ROFL
2011: 105.26% - 16.08% = 89.18%

2010: 43.98% - 13.80% = 30.17%
2009: 22.07% - 8.51% = 13.56%
continued next page

5-14
E5-29. concluded
c. ROE and ROA should be slightly higher in 2007 because of the extra week.
d. Net Profit Margin
2011: $850 / $10,364 = 8.20%

2010: $805 / $9,613 = 8.37%
2009: $448 / $8,632 = 5.19%
Asset Turnover
2011: $10,364 / [($6,108+$6,451) / 2] = 1.650

2010: $9,613 / [($6,451+$7,173) / 2] = 1.411
2009: $8,632 / [($7,173+$6,972) / 2] = 1.221
Financial Leverage
2011:
2010:
2009:
[($6,108+$6,451) / 2] / [($138+$1477) / 2] = 7.776

[($6,451+$7,173) / 2] / [($1,477+$2,184) / 2] = 3.721
[($7,173+$6,972) / 2] / [($2,184+$1,875) / 2] = 3.485
Limited Brands ROA increased slightly from 2010 to 2011 (mostly due to better
asset turnover), but its ROE skyrocketed! During both 2011 and 2010, Limited
Brands borrowed, paid dividends to shareholders and used cash to repurchase and
retire common shares. Its debt-to-equity ratio is 43.3 at the end of fiscal year 2011,
so the ROE is greater than 100%. This level of returns is exceptional for
shareholders, but the companys condition could be precarious if its performance
were to deteriorate.
The DuPont analysis shows that the net profit margin decreased from 2010 to 2011,
but the asset turnover improved significantly. Based on ROFL, leverage increased
ROA by 2.6 times in 2009 (22.07%/8.51%) while in 2011, leverage increased ROA
by a factor of 6.5 (105.26%/16.08%). DuPont analysis suggests that leverage had a
slightly larger impact (3.485 in 2009 and 7.776 in 2011) but the trend is the same.
This is consistent with the bias in DuPont analysis in that it tends to overstate the
effects of financial leverage. Offsetting this bias, DuPont analysis calculates the net
profit margin, which is lower than PM because the numerator is net of interest costs.
For comparison purposes, Nordstroms PM ratios are presented below:
PM ratio
2011: [$850+$246x (1-.35)] / $10,364 = 9.74%

2010: [$805+$208x (1-.35)] / $9,613 = 9.78%
2009: [$448+$237x(1-.35)] / $8,632 = 6.97%

5-15
E5-30. (20 minutes)

($ millions)
a. EWI
$984+$174x(1-.35) = $1,097.1
Avg. Equity
($7,022+$6,951)/2 = $6,986.5
Avg. Assets
($13,431+$13,912)/2 = $13,671.5
ROE
$984 / $6,986.5 = 14.08%
ROA
$1,097.1/ $13,671.5 = 8.02%
ROFL
14.08% - 8.02% = 6.06%
b. PM
AT
$1,097.1 / $25,022 = 4.49%

$25,022 / $13,671.5 = 1.83
c. Staples has a relatively low profit margin and an asset turnover that is close to 2.0.
This ratio combination is consistent with a low-price, high-volume business model.
However, compared to the retail industry, Staples is doing just a little above the
median on both of these ratios. As a result its ROA is above the industry median,
but its ROE is lower (reflecting a lower ROFL).
E5-31. (20 minutes)
($ millions)
a.
b.
EWI
$634+$60x(1-.35) = $673.0
Avg. Equity
($2,616+$2,821)/2 = $2,718.5
Avg. Assets
($5,110+$5,198)/2 = $5,154.0
ROE
$634 / $2,718.5= 23.32%
ROA
$673.0/ $5,154.0= 13.06%
ROFL
23.32% - 13.06% = 10.26%
PM
$673.0/ $3,851 = 17.48%
AT
$3,851 / $5,154.0= 0.747
c.
Intuit has a relatively high PM ratio and a low AT ratio. These numbers are
consistent with the business model employed in the software industry. Contrast these
numbers with those of Staples (E5-30). Intuit uses financial leverage effectively;
leverage increased its ROA by a factor of 1.79 (23.32%/13.06%).
5-16
E5-32. (30 minutes)

a.
($ millions)
Current Ratio
2009
$3,223 / $7,249 = 0.445
2010
$8,886 / $8,234 = 1.079
2011
$8,573 / $13,241 = 0.647
The big differences between 2010 and 2011 can be attributed, in part, to Comcasts
acquisition of 51% of NBC Universal. At the end of 2011, Comcast has a current
ratio less than 1.0 and does not appear to be very liquid. While the current ratio
provides a useful point estimate of liquidity, it would be helpful to know when the
cash flows from current assets will be realized and when the current liabilities will
need to be paid. Although current assets remained pretty constant from 2010 to
2011, there was a big decline in cash and a big increase in receivables. And the
increase in current liabilities was due to operating liabilities, not an increase in
financial liabilities.
b.
($ millions)
Times interest earned
Debt-to-equity
2009
$(5,106+2,348) / $2,348 = 3.17
$69,922 / $42,811 = 1.63
2010
$(6,104+2,156) / $2,156 = 3.83
$74,100 / $44,434 = 1.67
2011
$(8,207+2,505) / $2,505 = 4.28
$110,163 / $47,655 = 2.31
The times interest earned ratio is improving, probably due to increasing profits and
the favorable interest rate environment in these years. Comcast is able to cover its
interest expense by a margin that is above the median for the industry.. Comcasts
debt-to-equity ratio is relatively high and growing at 2.31, which is above the industry
median.
c. Comcasts current ratio is significantly lower than the industry median (0.647 versus
1.41) and bears watching. Further examination of the cash flows from operating
activities could be useful. At present, Comcast is able to cover its interest expense
by a margin that exceeds the median for the industry (4.30 versus 3.12). Comcasts
debt-to-equity ratio is relatively high and growing at 2.31, which is above the industry
median, 1.76.
d. Comcast has a relatively high level of debt and relatively low liquidity. However, its
increasing profitability and interest coverage that is above the industry median
provide some reassurance that it will be able to service its liabilities and continue to
make further investments.

5-17
E5-33. (30 minutes)

a.
($ millions)
Current Ratio
OCFCL
2009
43,634 / 36,486 = 1.196
6,246/[(42,451+36,486)/2] = 0.158
2010
49,648 / 40,591 = 1.223
9,447/[(36,486+40,591)/2] = 0.245
2011
52,813 / 43,560 = 1.212
7,767/[(40,591+43,560)/2] = 0.185
Siemens has a current ratio that is above 1.0 and has been steady over these years.
However, its OCFCL ratio improved in 2011 and 2010 relative to 2009. While the
current ratio provides a useful point estimate of liquidity, the OCFCL ratio suggests
that operations are not generating sufficient net cash flow to cover short-term
obligations, but it would be useful to also get a sense of the volume of resource
flows relative to the current liabilities.
b.
($ millions)
Times interest earned
Debt-to-equity
2009
(3,891+2,213) / 2,213 = 2.76
67,639 / 27,287 = 2.48
2010
(5,811+1,890) / 1,890 = 4.07
73,731 / 29,096 = 2.53
2011
(9,242+1,716) / 1,716 = 6.39
72,087 / 32,156 = 2.24
The times interest earned ratio is increasing and at acceptable levels, but is
increasing due to lower interest costs and higher earnings. Siemens debt-to-equity
ratio is quite high between 2.25 and 2.5.
c. Its always a good idea to look into the numbers that make up the ratios before
coming to conclusions. For instance, Siemens current liabilities include about 12.5
billion in unearned revenue, representing more than a quarter of its current liabilities.
In the normal course of business, this liability doesnt need to be paid rather
Siemens must provide the agreed-upon services and products to the customers.
Its not easy to place Siemens into one of the industry groups in Exhibit 5.13, but its
DE ratio appears to be higher than any industry median except tobacco and utilities.
However, its TIE appears to be in a satisfactory range. And, the companys size and
diversified businesses give it a stability that can reassure lenders.

5-18
E5-34. (30 minutes)

($ millions)
a.
b.
c.
EWI
$833+$74x(1-.35) = $881.1
Avg. Equity
($2,755+$4,080)/2 = $3,417.5
Avg. Assets
($7,422+$7,065)/2 = $7,243.5
ROE
$833 / $3,417.5= 24.37%
ROA
$881.1/ $7,243.5= 12.16%
ROFL
24.37% - 12.16% = 12.21%
PM
$881.1/ $14,549 = 6.06%
AT
$14,549 / $7,243.5= 2.009
GPM
$5,274 / $14,549 = 36.25%
INVT
$9,275 / [($1,615 + $1,620)/2] = 5.734
d. The Gap showed strong performance in the year ended January 28.2012 (hereafter,
2011), though not as strong as 2010. Its ROA was 12.16%, which is high for the
retail industry. ROE was over 22% indicating the effective use of financial leverage.
Interest costs were low, suggesting that most of The Gaps debt is from operating
liabilities (accounts payable and accrued expenses). Its profit margin and asset
turnover ratios place The Gap in a strong position for this industry.
The GPM and INVT ratios are two important performance measures for retail
companies such as The Gap. GPM measures the ability of the firm to sell its
merchandise at reasonable margins while INVT provides evidence on inventory
management and the popularity of its product line. Both measures are healthy for a
retailer in the economy of 2011.

5-19
E5-35. (20 minutes)

a, b.
THE GAP, INC.
Common-size and Pro-forma Income Statements
2012 Pro forma
2011
2010
Net Sales.
100.0%
100.0%
$15,000
Cost of goods sold and occupancy
costs...
63.8%
59.8%
9,600
Gross profit..
36.2%
40.2%
5,400
Operating expenses...
26.4%
26.7%
3,900
Operating income
9.9%
13.4%
1,500
Interest income
0.5%
-0.1%
-5
Interest expense.
0.0%
0.0%
74
Earnings from continuing operations
before income taxes....
9.4%
13.5%
1,431
Income taxes...
3.7%
5.3%
558
Net earnings...
5.7%
8.2%
$ 873
c. The Gaps pro forma statements are based on a set of assumptions that determine
the relationship between various expense items and sales revenue. The accuracy of
the projection depends on the reliability of these estimates, which depends on
managements ability to maintain a stable GPM ratio, maintain INVT ratio, and
control operating expense ETS ratios.

5-20
PROBLEMS
P5-36. (45 minutes)
($ millions)
a.
Nike
Adidas
EWI
$2,223+$33x(1-.35) = $2,244.5
670 + 115x(1-.30) = 750.5
Avg. Equity
($10,381+$9,843)/2 = $10,112.0
(5,331+4,623)/2 = 4,977.0
Avg. Assets
($15,465+$14,998)/2=$15,231.5
(11,380+10,618)/2 = 10,999.0
ROE
$2,223/ $10,112.0= 21.98%
670/4,977.0=13.46%
ROA
$2,244.5/ $15,231.5= 14.74%
750.5/10,999.0=6.82%
ROFL
21.98% - 14.73% = 7.25%
13.46% - 6.82% = 6.64%
Nikes performance on both measures of profitability exceeded that of Adidas. We can

examine possible reasons for that difference by looking at the ratios below.
b.
PM
$2,244.5/ $24,128 = 9.30%
750.5/13,344 = 5.62%
AT
$24,128 / $15,231.5= 1.584
13,344 /10,999.0= 1.213
Nikes PM ratio is significantly higher than Adidass, as is its AT ratio. So, Nikes higher
ROA appears to be driven by both superior margins and more efficient use of assets.
c.
GPM
$10,471 / $24,128 = 43.40%
6,344/13,344 = 47.54%
Operating ETS
$7,431 / $24,128 = 30.80%
5,333/13,344 = 39.97%
Adidas reports a higher GPM ratio than Nike by about 4%. However, that is more than
offset by higher operating expenses as a percentage of sales.
d.
ART
$24,128 /$[(3,280+3,138)/2]=7.519
13,344 /[(1,707+1,667)/2]=7.910
INVT
$13,657/$[(3,350+2,715)/2]=4.504
7,000/[(2,482+2,119)/2]=3.043
PPET
$24,128 /$[(2,279+2,115)/2]=10.982
13,344 /[(963+855)/2]=14.680
Nikes INVT is significantly higher than Adidass, suggesting that Nike may be managing
inventory more efficiently. Adidas has a higher PPET ratio, though both companies ratios
are high. These are consistent with a business model that outsources most of the
production.
continued next page

5-21
P5-36. concluded
e. The two companies fiscal years overlap by seven months. Nikes income statement
includes January through May 2012 while Adidas statements cover January through
May 2011. (Both cover June through December 2011.) Economic conditions were
not materially different in 2012 than 2011, so the comparisons involving income
statement accounts shouldnt be affected too much.
However, companies that experience seasonality will have balance sheets that look
different at different points in time. For instance, a company might have lower
inventory levels just after a busy season, and choosing that point for the end of its
fiscal year would produce a higher value for INVT than a fiscal year just prior to its
busy season.
f. Normally, we would want to identify any major differences in the valuation of assets
and the measurement of income between these two companies. For example, some
assets are more likely to be valued at current value (rather than historical cost)
under IFRS reporting. Such a difference would affect ratios such as ROA, AT, INVT
and PPET.
P5-37. (20 minutes)
($ millions)
a. Current Ratio
Quick Ratio
Nike
Adidas
2012: $11,531/$3,865 = 2.983
2011: 6,435/4,281= 1.503
2011: $11,297/$3,958 = 2.854
2010: 5,880/3,908= 1.505
2012: $(2,317+1,440+3,280)/$3,865=1.821
2011: (906+465+1,707)/4,281=0.719
2011: $(1,955+2,583+3,138)/$3,865=1.939
2010: (1,156+233+1,667)/3,908= 0.782
Nike is more liquid than Adidas. Its current ratio is just under 3.0 and its quick ratio is
almost 2.0. In fact, Nikes quick ratio is higher than Adidass current ratio.
b. TIE
Debt-to-Equity
2012: ($2,983+$33)/$33=91.39
2011: (927+115)/115=9.06
2011: ($2,844+$34)/$34=84.65
2010: (806+113)/113= 8.13
2012: $5,084/$10381=0.490
2011: 6,049/5,331=1.135
2011: $5,155/$9,843=0.524
2010: 5,995/4,623=1.297
Nikes debt-to-equity ratio is very low and decreased slightly in 2012. Adidass debt-toequity ratio is higher, but also went down in 2011. Both companies reported increasing
TIE ratios.
c.
Adidas relies on significantly greater amounts of debt financing than does Nike. This is
evident by the debt-to-equity ratio. In addition, the TIE ratio for Nike is 9 times higher than
for Adidas. Although Adidass TIE ratio is not too low, Nikes small amount of interest
expense produces a very high TIE. Neither company should have difficulty meeting its
debt obligations, but Adidas may not be able to borrow as much in the future (if needed).

5-22
P5-38. (45 minutes)

($ millions)
a.
Home Depot
Lowes
EWI
$3,883+$606x(1-.35) = $4,276.9
$1,839+$379x(1-.35) = $2,085.4
Avg. Equity
($17,898+$18,889)/2= $18,393.5
($16,533+$18,112)/2= $17,322.5
Avg. Assets
($40,518+$40,125)/2=$40,321.5
($33,559+$33,699)/2=$33,629
ROE
$3,883/ $18,393.5= 21.11%
$1,839/ $17,322.5= 10.62%
ROA
$4,276.9/ $40,321.5= 10.61%
$2,085.4/ $33,629= 6.20%
ROFL
21.11% - 10.61% = 10.50%
10.62% - 6.20% = 4.42%
In 2011, Home Depots profitability exceeded that of Lowes, both in return to

shareholders and in return on assets. Home Depot also had a larger proportional
effect from the use of leverage.
b.
PM
$4,276.9/ $70,395 = 6.08%
$2,085.4/ $50,208 = 4.15%
AT
$70,395 / $40,321.5= 1.746
$50,208 / $33,629= 1.493
Home Depot has a higher PM ratio, so it makes more money for every dollar of
sales, and it also generates more sales for every dollar of resources, suggesting
that it is managing assets more efficiently.
c.
GPM
$24,262 / $70,395 = 34.47%
$17,350 / $50,208 = 34.56%
Operating ETS
$17,601 / $70,395 = 25.00%
$14,073 / $50,208 = 28.03%
These two companies have almost identical gross profit margins. Lowes GPM ratio
is slightly higher than that of the Home Depot, but its operating ETS ratio is higher.
Overall, Home Depot performed slightly better with respect to these two profitability
measures.
d.
ART
$70,395 /$[(1,245+1,085)/2]=60.43
$50,208 /0 = N/A
INVT
$46,133/$[(10,325+10,625)/2]=4.40
$32,858/$[(8,355+8,321)/2]=3.941
PPET
$70,395 /$[(24,448+25,060)/2]=2.844
$50,208 /$[(21,970+22,089)/2]=2.279
Lowes reports no accounts receivable and Home Depot reports very small
amounts of receivables. Neither company relies on customer credit to generate
sales, so the ART ratio is not very informative. More important is the INVT ratio.
Home Depots INVT is more than 10% higher than Lowes ratio. The same is true
for the PPET ratio. These differences are consistent with the difference in the AT
ratios noted earlier. Overall, the numbers suggest that Home Depot is managing
inventories and PPE assets more efficiently.
e. Overall, It appears that Home Depot performed better than Lowes in 2011. Its ratio
values are either equal to or better than Lowes in almost every category. Over this
time period, Home Depots stock price increased substantially (on the order of
30%), while Lowes stock price was relatively unchanged.
5-23
P5-39. (30 minutes)

($ millions)
a.
Current Ratio
Quick Ratio
Home Depot
Lowes
2011: $14,520/$9,376 = 1.549
2011: $10,072/$7,891 = 1.276
2010: $13,479/$10,122 = 1.332
2010: $9,967/$7,119 = 1.400
2011: $(1,987+1,245)/$9,379=0.345
2011: $(1,014+286)/$7,891=0.165
2010: $(545+1,085)/$10,122=0.161
2010: $(652+471)/$7,119=0.158
The current ratios of these two companies are very close in 2010, but diverged in
2011, with Home Depot improving and Lowes declining. Both are above one.. Quick
ratios are very low due to the lack of receivables and low cash balances. Both
companies rely on operating cash flow to cover liquidity needs. Given the lack of
receivables, the INVT ratio becomes doubly important (see P5-38). Failure to turn
inventories quickly would result in lower operating cash flow and liquidity problems.
Hence, both companies emphasize inventory management.
b.
TIE
Debt-to-Equity
2011: ($6,068+$606)/$606=11.013
2011: ($2,906+$379)/$379=8.668
2010: ($5,273+$530)/$530=10.949
2010: ($3,228+$340)/$340=10.494
2011: $22,620/$17,898=1.264
2011: $17,026/$16,533=1.030
2010: $21,236/$18,889=1.124
2010: $15,587/$18,112=0.861
For both companies, the debt-to-equity ratio increased from 2010 to 2011indicating
more reliance on debt financing. Despite this trend, Home Depots TIE ratios
increased. Lowes TIE decreased due to declining earnings and increased interest
expense.
c. The Home Depot utilizes more debt financing than does Lowes and is slightly higher
than the median retail firm. This results in a higher ROFL (see P5-38), as well as
higher debt-to-equity. Both firms have TIE ratios that are above the median for the
retail industry.

5-24
P5-40.A (20 minutes)

($ millions)
a.
Home Depot
Lowes
NOPAT
$3,883+$(606 - 13)x(1 - .35) = $4,268.45
$1,839+$(379 - 8)x(1 - .35) = $2,080.15
NOA
2011: $(40,518 - 135) - $(22,620 30 10,758) = $28,551
2011: $(33,559 - 286-504) - $(17,026

592 - 7,035) = $23,370
2010: $(40,125-139) - $(21,236 - 1,042 8,707) = $28,499
2010: $(33,699 - 471-1,008) - $(15,587

36 - 6,537) = $23,206
Avg. NOA
($28,551 + $28,499)/2 = $28,525.0
($23,370 + $23,206)/2 = $23,288.0
b.
RNOA
$4,268.45/$28,252.0 = 14,96%
$2,080.15/$23,288.0 = 8.93%
c.
NOPM
$4,268.45/$70,395 = 6.06%
$2,080.15/$50,208 = 4.14%
NOAT
$70,395/$28,525 = 2.468
$50,208/$23,288 = 2.156
d. Lowes reports a lower RNOA than does The Home Depot, and the pattern in the
operating results parallels that in the total-firm results in P5-38. This is consistent with
the ROA numbers computed in P5-38 (ROA=10.61% for Home Depot and 6.20% for
Lowes). Overall, we would expect operating companies to have higher RNOA than
ROA, because their core business is the operations of the company, not investing in
financial assets. And, if management seeks to earn a favorable return for shareholders,
they must expect a higher return on their operations than they have to pay for borrowed
funds.

5-25
P5-41. (30 minutes)

($ millions)
a.
2011
2010
EWI
$3,804+$348x(1-.35) = $4,030.2
$3,338+$354x(1-.35) = $3,568.1
Avg. Assets
($34,701+$33,597)/2=$34,149.0
($33,597+$31,882)/2=$32,740.0
ROA
$4,030.2/ $34,149.0= 11.80%
$3,568.1/ $32,740.0= 10.90%
PM
$4,030.2/ $53,105 = 7.59%
$3,568.1/ $49,545 = 7.20%
AT
$53,105 / $34,149.0= 1.555
$49,545 / $32,740.0= 1.513
UPS return on assets appears healthy in both years. Although AT increased slightly in 2011,
the primary cause of the increase in ROA was an increase in PM from 7.20% to 7.59%.
b.
Compensation ETS
$27,575/$53,105 = 51.93%
$26,557/$49,545 = 53.60%
The largest single expense on UPSs income statement is compensation. Reducing this
expense by almost 2 percentage points (of sales) caused UPSs profit margin to increase in
2011.
c.
d.
Avg. Equity
($7,108+$8,047)/2= $7,577.5
($8,047+$7,696)/2= $7,871.5
ROE
$3,804/ $7,577.5 = 50.20%
$3,338/ $7,871.5 = 42.41%
ROFL
50.20% - 11.80% = 38.40%
42.41% - 10.90% = 31.51%
UPS relies heavily on debt financing. In 2011 and 2010, when ROA was at an acceptable
level, ROFL produced an ROE between 3 and 4 times as large as ROA.

5-26
P5-42. (30 minutes)

($ millions)
a.
2011
2010
Current Ratio
$12,284/$6,514 = 1.886
$11,569/$5,902 = 1.960
Quick Ratio
$(3,034+1,241+6,246)/$6,514=1.615
$(3,370+711+5,627)/$5,902=1.645
UPS current and quick ratios decreased slightly in 2011. The current ratio is close to 2.0
and the quick ratio is only slightly lower than the current ratio because UPS does not
carry inventory balances.
b.
TIE
($5,776+$348)/$348=17.598
($5,290+$354)/$354=15.944
Debt-to-Equity
$27,593/$7,108=3.882
$25,550/$8,047=3.175
The TIE ratio increased dramatically in 2011 due to the increase in earnings. However,
the debt-to-equity ratio also increased, indicating an increased dependence on debt
financing.
c. UPS relies heavily on liability financing. The companys current ratio and quick ratio are
in line with the medians of the Business Services industry but, being a capital-intensive
business, their debt-to-equity ratio is significantly higher than the median. Although the
company appears liquid, its ability to meet its obligations depends heavily on operating
cash flow. The high (and increasing) debt-to-equity ratio suggests that UPS may have
difficulty borrowing additional funds if needed.
P5-43.A (30 minutes)
($ millions)
a.
United Parcel Service (UPS)
NOPAT
$3,804+$(348-44)x(1-.35) = $4001.6
NOA
2011: $(34,701-1,241-303) - $(27,593-33-11,095) = $16,692

2010: $(33,597-711-458) - $(25,550-355-10491) = $17,724
Avg. NOA
($16,692 + $17,724)/2 = $17,208
b.
RNOA
$4001.6/$17,208 = 23.25%
c.
NOPM
$4001.6/$53,105 = 7.54%
NOAT
$53,105/$17,208 = 3.086
d. UPS invests only small amounts in non-operating assets (less than 5% of total
assets). So, when UPS invests borrowed funds in its operations, it earns a return
above 20%, at least in 2011. Because its borrowing costs are significantly less than
20%, the financial leverage works in favor of the shareholders.

5-27
P5-44.B (45 minutes)

a.
UNITED PARCEL SERVICE, INC.
Income Statements
2011
Actual
$53,105
27,575
19,450
47,025
6,080
44
(348)
5,776
1,972
$ 3,804
($ millions)
Revenue
Compensation and benefits..
Other..
Operating profit
Investment income..
Interest expense
Income before income taxes..
Income taxes..
Net income..
2012
Pro forma
$57,000
29,597
20,877
50,474
6,526
44
(348)
6,222
2,178
$40,449

Balance Sheets
($ millions)
Cash and equivalents.
Marketable securities..
Accounts receivable, net
Deferred income taxes
Other current assets..
Total current assets
Property, plant and equipment.
Goodwill
Intangible assets..
Non-current investments and restricted cash
Other assets.
Total assets..
Current maturities of long-term debt

Accounts payable.
Accrued wages and withholdings.
Self-insurance reserves .
Other current liabilities
Total current liabilities
Long-term debt.
Pension and postretirement obligation
Deferred taxes liabilities..
Other noncurrent liabilities..
Total liabilities...
Shareowners' equity
Total liabilities and shareowners' equity..
2011
Actual
3,034
1,241
6,246
611
1,152
12,284
17,621
2,101
585
303
1,807
34,701
2012
Pro forma
$ 4,055
1,241
6,704
656
1,236
13,892
18,913
2,255
628
303
1,940
$37,931
33
2,300
1,843
781
1,557
6,514
11,095
5,505
1,900
2,579
27,593
7,108
34,701
$ 33
2,469
1,978
838
1,671
6,989
11,095
5,909
2,039
2,768
28,801
9,130
$37,931
continued next page

5-28
P5-44.B concluded
b.
Cash Flow Statement
($ millions)
Operations:
Net income.
Adjustments:
Depreciation and amortization.....
Less change in operating assets:
Accounts receivable
Deferred income taxes
Other current assets
Plus change in operating liabilities:
Accounts payable
Accrued wages and withholdings..
Self-insurance reserves
Other current liabilities..
Accumulated postretirement benefit obligation..
Deferred taxes and other liabilities.
Other noncurrent liabilities
Cash flow from operations
2012
Pro forma
$4,044
1,995
(458)
(45)
(84)
169
135
57
114
404
139
189
6,659
Investing activities:
Investment in property, plant and equipment.
Investment in goodwill and intangible assets.
Investment in other noncurrent assets
Cash used for investing activities...
(3,287)
(197)
(133)
(3,617)
Financing activities:
Dividends paid..
Cash used for financing activities...
(2,022)
(2,022)
Net increase in cash

Cash, December 31, 2011..
Pro forma cash, December 31, 2012..
1,020
3,034
1
4,054
Off by $1 from the pro forma balance sheet due to rounding.

5-29
P5-45. (20 minutes)

a. Avg. total liabilities
($27,593+$25,550)/2 = $26,571.5
Net interest rate (NIR)
$348x(1-.35) / 26,571.5 = 0.85%
Spread (ROA NIR)
11.80%-0.85% = 10.95%
b. ROFL
{[26,571.5]/[7,577.5]}x10.96% = 38.4%
c. An ROFL of 38.4% is equal to the difference between ROE and ROA (50.2%-11.8%)
as calculated in P5-41. This suggests that 76% of UPSs ROE was generated by
the effective use of financial leverage.
P5-46. (45 minutes)
a, b.
A summary of the ratios for these five companies appears in the following table.
Calculations are provided below for each company.
ABT
BMY
JNJ
GSK
PFE
PM
13.06%
25.20%
15.44%
22.07%
16.53%
GPM
60.00%
73.65%
68.69%
73.23%
77.63%
R&D ETS
10.63%
18.07%
11.61%
14.64%
13.51%
SG&A ETS
32.84%
24.29%
32.25%
32.23%
28.87%
c. What is perhaps most remarkable is how similar these five companies are. For
example, the SG&A ETS ratio ranges between 24% and 33%, with three of the five
AT 32%. GPM ranges from a low of 60% (ABT) to 78% (PFE), but the other three
firms are between 69% and 74%. This suggests that the business models employed
by these companies are very similar. The PM ratio shows a fairly wide variation,
ranging from a low of 13% (ABT) to 25% (BMY). Interestingly, ABT appears to be
the least profitable, with the lowest PM and GPM, yet it spends the least on R&D. At
the same time, BMY has the highest PM and spends the most on R&D.
continued next page

5-30
P5-46. concluded
Calculations of ratios for each firm follow:
($ millions)
PM
GPM
Abbott Laboratories (ABT)

$4,728 + $530 x(1-.35) / $38,851 = 13.06%
($38,851 - $15,541) / $38,851 = 60.00%
R&D ETS
$4,129 / $38,851 = 10.63%
SG&A ETS
$12,757 / $38,851 = 32.84%
($ millions)
Bristol-Myers Squibb (BMY)
PM
GPM
$5,260 + $145 x(1-.35) / $21,244 = 25.20%

($21,244 - $5,598) / $21,244 = 73.65%
R&D ETS
$3,839 / $21,244 = 18.07%
SG&A ETS
$5,160 / $21,244 = 324.29%
($ millions)
Johnson & Johnson (JNJ)
PM
GPM
$9,672 + $571 x(1-.35) / $65,030 = 15.44%

($65,030 - $20,360) / $65,030 = 68.69%
R&D ETS
$7,548 / $65,030 = 11.61%
SG&A ETS
$20,969 / $65,030 = 32.25%
($ millions)
GlaxoSmithKline (GSK)
PM
GPM
5,458+ 799x(1-..265) / 27,387= 22.07%

(27,387- 7,332) / 27,387= 73.23%
R&D ETS
4,009/ 27,387= 14.64%
SG&A ETS
8,826/ 27,387= 32.23%
($ millions)
Pfizer (PFE)
PM
GPM
$10,051 + $1,681 x(1-.35) / $67,425 = 16.53%

($67,425- $15,085) / $67,425= 77.63%
R&D ETS
$9,112 / $67,425= 13.51%
SG&A ETS
$19,468 / $67,425= 28.87%

5-31
P5-47. (45 minutes)

ROA
PM
AT
ART
INVT
PPET
GPM
Best Buy
0.64%
0.22%
3.00
21.87
6.56
13.90
24.8%
Kroger
3.74%
0.97%
3.85
100.75
14.19
6.32
20.9%
Nordstrom
9.64%
7.07%
1.36
5.36
6.20
4.54
39.4%
Staples
8.03%
4.38%
1.83
12.50
7.63
11.84
26.9%
Walgreens
10.32%
3.84%
2.69
29.18
6.70
6.36
28.4%
Nordstrom (JWN) has the highest PM (7.07%) and the highest GPM (39.4%). It also
has the lowest AT (1.36), ART (5.36), INVT (6.20) and PPET (4.54). JWN clearly
achieves its ROA by emphasizing high profit margin. Kroger (KR) is at the opposite
extreme from Nordstrom, emphasizing efficient asset management. Kroger has the
highest AT and INVT. Inventory management is critical for a retail grocer. It also has
very few receivables, so its ART is very high (100.75 times). Fiscal year 2011 was not a
successful one for Best Buy (BBY), with very low PM.
Retail companies lease much of their store space. As a result, the PPET ratio depends
on how these store leases are reported in the balance sheet. Lease accounting is
discussed in Chapter 10.
Calculations follow for each firm ($ millions):
Best Buy (BBY)
EWI
$22 + $134 x (1-.35) = $109.10
ROA
$109.1/ $16,927 = 0.64%
PM
$109.1/ $50,705 = 0.22%
AT
$50,705 / $16,927 = 3.00
ART
$50,705 $2,318 = 21.87
INVT
$38,113 / $5,814 = 6.56
PPET
$50,705 / $3,647 = 13.90
GPM
($50,705 - $38,113) / $50,705 = 24,8%
EWI
Kroger (KR)
$596 + $435 x (1-.35) = $878.75
ROA
$878.75/ $23,491 = 3.74%
PM
$878.75/ $90,374 = 0.97%
AT
$90,374 / $23,491 = 3.85
ART
$90,374 / $897 = 100.75
INVT
$71,494 / $5,040 = 14.19
PPET
$90,374 / $14,306 = 6.32
GPM
($90,374 - $71,494) / $90,374 = 20.9%

continued next page

5-32
P5-47. concluded
EWI
Nordstrom (JWN)
$683 + $132 x (1-.35) = $768.80
ROA
$768.80/ $7,977 = 9.64%
PM
$768.80/ $10,877 = 7.07%
AT
$10,877/ $7,977 = 1.36
ART
$10,877/ $2,030 = 5.36
INVT
$6,592 / $1,063 = 6.20
PPET
$10,877/ $2,394 = 4.54
GPM
($10,877- $6,592) / $10,877= 39.4%
EWI
Staples (SPLS)
$984 + $174 x (1-.35) = $1,097.10
ROA
$1,097.10/ $13,671 = 8.03%
PM
$1,097.10/ $25,022 = 4.38%
AT
$25,022 / $13,671 = 1.83
ART
$25,022 / $2,002 = 12.50
INVT
$18,280 / $2,396 = 7.63
PPET
$25,022 / $2,114 = 11.84
GPM
($25,022 - $18,280) / $25,022 = 26.9%
EWI
Walgreen (WAG)
$2,714 + $89 x (1-.35) = $2,771.85
ROA
$2,771.85/ $26,865 = 10.32%
PM
$2,771.85/ $72,184 = 3.84%
AT
$72,184 / $26,865 = 2.69
ART
$72,184 / $2,474 = 29.18
INVT
$51,692 / $7,711 = 6.70
PPET
$72,184 / $11,355 = 6.36
GPM
($72,184 - $51,692) / $72,184 = 28.4%

5-33
CASES and PROJECTS

C5-48. (30 minutes)
a. Raising prices and/or reducing manufacturing costs are not necessarily independent
solutions and are likely related to other factors. The effect of a price increase on
gross profit is a function of the demand curve for the companys product. If the
demand curve is relatively elastic, a price increase will likely significantly reduce
demand, thereby decreasing, rather than increasing, gross profit (an example is a
10% increase in price and a 20% decrease in demand). A price increase will have a
more desired effect if the demand curve is relatively inelastic (a 10% price increase
with a 3% decrease in demand).
Cutting manufacturing costs will positively affect gross profit (via reduction of COGS)
if the more inexpensively made product is not perceived to be of lesser quality,
thereby reducing demand.
b. Raising prices is difficult in competitive markets. As the number of product
substitutes increases, companies are less able to raise prices. Rather, they must be
able to effectively differentiate their products in some manner in order to reduce
consumers substitution. This can be accomplished, for example, by product design
and/or advertising. These efforts, however, likely entail additional cost, and, while
gross profit might be increased as a result, SG&A expense may also increase with
little effect on the bottom line.
Manufacturing costs consist of raw materials, labor and overhead. Each can be
targeted for cost reduction. A reduction of raw materials costs generally implies
some reduction in product quality, but not necessarily. It might be the case that the
product contains features that are not in demand by consumers. Eliminating those
features will reduce product costs with little effect on selling price.
Similarly, companies can utilize less expensive sources of labor (off-shore
production, for example), that can significantly reduce product costs and increase
gross profit provided that product quality is maintained.
Finally, manufacturing overhead can be reduced by more efficient production.
Wages and depreciation expense are two significant components of manufacturing
overhead. These are largely fixed costs, and the per-unit product cost can often be
reduced by increasing capacity utilization of manufacturing facilities (provided, of
course, that the increased inventory produced can be sold).
The bottom line is that increasing gross profit is a difficult process than can only be
accomplished by effective management and innovation.

5-34
C5-49. (30 minutes)

a. Working capital management is an important component of the management of a
company. By reducing the level of working capital, companies reduce the costs of
carrying excess assets. This can have a significantly positive effect on financial
performance. Some common approaches to reducing working capital via reductions
in receivables and inventories, and increases in payables, include the following:
Reduce receivables
Constricting the payment terms on product sales
Better credit policies that limit credit to high-risk customers
Better reporting to identify delinquencies
Automated notices to delinquent accounts
Increased collection efforts
Prepayment of orders or billing as milestones are reached
Use of electronic (ACH) payment
Use of third-party guarantors, including bank letters of credit
Reduce inventories
Reduce inventory costs via less costly components (of equal quality), produce
with lower wage rates, eliminate product features (costs) not valued by
customers
Outsource production to reduce product cost and/or inventories the company
must carry on its balance sheet
Reduce raw materials inventories via just-in-time deliveries
Eliminate bottlenecks in manufacturing to reduce work-in-process inventories
Reduce finished goods inventories by producing to order rather than
producing to estimated demand
Increase payables
Extend the time for payment of low or no-cost payablesso long as the
relationship with suppliers is not harmed)
continued next page

5-35
C5-49. concluded
b. The terms of payment that a company offers to its customers is a marketing tool,
similar to product price and advertising programs. Many companies promote
payment terms separately from other promotions (no payment for six months or
interest-free financing, for example). As companies restrict credit terms, the level of
receivables will likely decrease, thereby reducing working capital. The restriction of
credit terms may also have the undesirable effect of reducing demand for the
companys products. The cost of credit terms must be weighed against the benefits,
and credit terms must be managed with care so as to optimize costs rather than
minimize them. Credit policy is as much art as it is science.
Likewise, the depth and breadth of the inventories that companies carry impact
customer perception. At the extreme, inventory stock-outs result in not only the loss
of current sales, but also the potential loss of future sales as customers are
introduced to competitors and may develop an impression of the company as thinly
stocked. Inventories are costly to maintain, as they must be financed, insured,
stocked, moved, and so forth. Reduction in inventory levels can reduce these costs.
On the other hand, the amount and type of inventories carried is a marketing
decision and must be managed with care so as to optimize the level inventories, not
necessarily to minimize them.
One companys account payable is anothers account receivable. So, just as one
company seeks to extend the time of payment, so as to reduce its working capital,
so does the other company seek to reduce the average collection period so as to
accomplish the same objective. Capable, dependable suppliers are a valuable
resource for the company, and the supplier relation must be handled with care. All
companies take as long to pay their accounts payable as the supplier allows in its
credit terms. Extending the payment terms beyond that point begins to negatively
impact the supplier relation, ultimately resulting in the loss of the supplier. The
supplier relation must be managed with care so as to optimize the terms of payment,
rather than necessarily to minimize them.

5-36
C5-50. (30 minutes)

a. The list of parties that are affected by schemes to manage earnings is often much
broader than first thought. It includes the following affected parties:
1. employees above and below the level at which the scheme is implemented
2. stockholders and elected members of the board of directors
3. creditors of the company (suppliers and lenders) and their employees,
stockholders, and boards of directors
4. competitors of the company
5. the companys independent auditors
6. regulators and taxing authorities
b. Managers often believe that earnings management activities will be short-lived, and
will be curtailed once its operations turn around. Often, this does not prove to be
the case. Interviews with managers and employees who have engaged in these
activities often reveal that they started rather innocuously (just managing earnings to
make the numbers in one quarter), but, quickly, earnings management became a
slippery slope. Ultimately, the parties the company was trying to protect
(shareholders, for example) are hurt more than they would have been had the
company reported its results correctly, exposing problems early so that corrective
action could be taken (possibly by removing managers) to protect the broader
stakeholders in the company.
c. Company managers are just ordinary people. They desire to improve their
compensation, which is often linked to financial performance. Managers may act to
maximize their current compensation at the expense of long-term growth in
shareholder value. The reduction in the average employment period at all levels of
the company has exacerbated the problem.
d. Unfortunately, the separation of ownership and control often leads to less informed
shareholders who are unable to effectively monitor the actions of the managers they
have hired. To the extent that compensation programs are linked to financial
measures, managers can use the flexibility given to them under GAAP to their
benefit, even without violating GAAP per se. These actions can only be uncovered
by effective auditing and enforced by an effective audit committee of the board.
Corporate governance has grown considerably in importance following the
accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new
levels of corporate governance. The stock market and the courts are helping to
enforce this mandate.

5-37

Analyzing and Interpreting Financial Statements: Learning Objectives - Coverage by Question

Uploaded by

Copyright:

Available Formats

Analyzing and Interpreting Financial Statements: Learning Objectives - Coverage by Question

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Analyzing and Interpreting Financial Statements: Learning Objectives - Coverage by Question

Uploaded by

Copyright:

Available Formats

Chapter 5

Analyzing and Interpreting Financial

LO5 Appendix 5A: Measure and

Cambridge Business Publishers, 2014

Return on investment measures profitability in relation to the amount of

Reducing advertising or R&D expenditures can increase current operating profit

ROE>ROA implies a positive return on financial leverage. This results from

Common-size financial statements express balance sheet and income

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

M5-16 (20 minutes)

M5-17. (15 minutes)

Short-term borrowings and current portion of long-term

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

M5-20. (15 minutes)

M5-21. (20 minutes)

Cambridge Business Publishers, 2014

M5-22. (15 minutes)

Average total assets = ($1,483.7 + $1,794.3)/2 = $1,639.0

PM = $1,526.5 / $23,191.5 = 6.58%

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

Cambridge Business Publishers, 2014

M5-24. (30 minutes)

Procter & Gamble ..............................

Procter & Gamble ..............................

Procter & Gamble ..............................

Procter & Gamble ..............................

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

[$2,929 + $869x(1-.35)] / $45,168 = 7.74%

[($16,387 + $2,322x(1-.35)] / $446,950 = 9.57%

AT = Sales / Avg. Assets

[$2,929 + $869x x(1-.35)] / $69,865 =

[($16,387 + $2,322x (1-.35)] / $446,950

continued next page

Cambridge Business Publishers, 2014

Financial Accounting, 4th Edition

E5-27. (20 minutes)

$3,839.2/ $63,356.0 = 6.06%

$2771.9/ $26,864.5 = 10,32%

$3,457 / $37,875.5= 9.13%

$2,714 / $14,623.5 = 18.56%

9.13% - 6.06% = 3.07%

18.56% - 10.32% = 8.24%

2011: $12,942 / [($45,911+$49,430) / 2] = 27.15%

2011: [$12,942+$41x(1-.35)] / [($71,119+$63,186) / 2] = 19.31%

2011: 27.15% - 19.31% = 7.84%

Cambridge Business Publishers, 2014

2011: $53,999 / [($71,119+$63,186) / 2] = 0.804

2011: [($71,119+$63,186) / 2] / [($45,911+$49,430) / 2] = 1.41

2011: [$12,942+$41x x(1-.35)] / $53,999 = 24.02%

E5-29. (30 minutes)

2011: $850 / [($138+$1,477) / 2] = 105.26%

2011: [$850+$246x(1-.35)] / [($6,108+$6,451) / 2] = 16.08%