Chapter 4

Analysis of Financial Statements

ANSWERS TO END-OF-CHAPTER QUESTIONS

4-1 a. A liquidity ratio is a ratio that shows the relationship of a firm’s cash and other
current assets to its current liabilities. The current ratio is found by dividing current
assets by current liabilities. It indicates the extent to which current liabilities are
covered by those assets expected to be converted to cash in the near future. The
quick, or acid test, ratio is found by taking current assets less inventories and then
dividing by current liabilities.

b. Asset management ratios are a set of ratios that measure how effectively a firm is
managing its assets. The inventory turnover ratio is sales divided by inventories.
Days sales outstanding is used to appraise accounts receivable and indicates the
length of time the firm must wait after making a sale before receiving cash. It is
found by dividing receivables by average sales per day. The fixed assets turnover
ratio measures how effectively the firm uses its plant and equipment. It is the ratio of
sales to net fixed assets. Total assets turnover ratio measures the turnover of all the
firm’s assets; it is calculated by dividing sales by total assets.

c. Financial leverage ratios measure the use of debt financing. The debt ratio is the ratio
of total liabilities to total assets, it measures the percentage of funds provided by non-
equity holders. The times-interest-earned ratio is determined by dividing earnings
before interest and taxes by the interest charges. This ratio measures the extent to
which operating income can decline before the firm is unable to meet its annual
interest costs. The EBITDA coverage ratio is similar to the times-interest-earned
ratio, but it recognizes that many firms lease assets and also must make sinking fund
payments. It is found by adding EBITDA and lease payments then dividing this total
by interest charges, lease payments, and sinking fund payments over one minus the
tax rate.

d. Profitability ratios are a group of ratios, which show the combined effects of liquidity,
asset management, and debt on operations. The profit margin on sales, calculated by
dividing net income by sales, gives the profit per dollar of sales. Basic earning power
is calculated by dividing EBIT by total assets. This ratio shows the raw earning
power of the firm’s assets, before the influence of taxes and leverage. Return on total
assets is the ratio of net income to total assets. Return on common equity is found by
dividing net income by common equity.

Answers and Solutions: 4 - 1

 e. Market value ratios relate the firm’s stock price to its earnings and book value per
share. The price/earnings ratio is calculated by dividing price per share by earnings
per share--this shows how much investors are willing to pay per dollar of reported
profits. The price/cash flow is calculated by dividing price per share by cash flow per
share. This shows how much investors are willing to pay per dollar of cash flow.
Market-to-book ratio is simply the market price per share divided by the book value
per share. Book value per share is common equity divided by the number of shares
outstanding.

f. Trend analysis is an analysis of a firm’s financial ratios over time. It is used to

estimate the likelihood of improvement or deterioration in its financial situation.
Comparative ratio analysis is when a firm compares its ratios to other leading
companies in the same industry. This technique is also known as benchmarking.

g. The Du Pont equation is a formula, which shows that the rate of return on assets can
be found as the product of the profit margin times the total assets turnover. Window
dressing is a technique employed by firms to make their financial statements look
better than they really are. Seasonal factors can distort ratio analysis. At certain
times of the year a firm may have excessive inventories in preparation of a “season”
of high demand. Therefore an inventory turnover ratio taken at this time as opposed
to after the season will be radically distorted.

4-2 The emphasis of the various types of analysts is by no means uniform nor should it be.
Management is interested in all types of ratios for two reasons. First, the ratios point out
weaknesses that should be strengthened; second, management recognizes that the other
parties are interested in all the ratios and that financial appearances must be kept up if the
firm is to be regarded highly by creditors and equity investors. Equity investors are
interested primarily in profitability, but they examine the other ratios to get information
on the riskiness of equity commitments. Long-term creditors are more interested in the
debt ratio, TIE, and fixed-charge coverage ratios, as well as the profitability ratios.
Short-term creditors emphasize liquidity and look most carefully at the liquidity ratios.

4-3 Given that sales have not changed, a decrease in the total assets turnover means that the
company’s assets have increased. Also, the fact that the fixed assets turnover ratio
remained constant implies that the company increased its current assets. Since the
company’s current ratio increased, and yet, its quick ratio is unchanged means that the
company has increased its inventories.

Answers and Solutions: 4 - 2

4-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset
turnover ratios to vary among industries. For example, a steel company needs a greater
number of dollars in assets to produce a dollar in sales than does a grocery store chain.
Also, profit margins and turnover ratios may vary due to differences in the amount of
expenses incurred to produce sales. For example, one would expect a grocery store chain
to spend more per dollar of sales than does a steel company. Often, a large turnover will
be associated with a low profit margin, and vice versa.

4-5 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for
firms with seasonal sales patterns. Therefore, those ratios that examine balance sheet
figures will vary unless averages (monthly ones are best) are used.

b. Common equity is determined at a point in time, say December 31, 20087. Profits are
earned over time, say during 20087. If a firm is growing rapidly, year-end equity will
be much larger than beginning-of-year equity, so the calculated rate of return on
equity will be different depending on whether end-of-year, beginning-of-year, or
average common equity is used as the denominator. Average common equity is
conceptually the best figure to use. In public utility rate cases, people are reported to
have deliberately used end-of-year or beginning-of-year equity to make returns on
equity appear excessive or inadequate. Similar problems can arise when a firm is
being evaluated.

4-6 Firms within the same industry may employ different accounting techniques, which make
it difficult to compare financial ratios. More fundamentally, comparisons may be
misleading if firms in the same industry differ in their other investments. For example,
comparing Pepsico and Coca-Cola may be misleading because apart from their soft drink
business, Pepsi also owns other businesses such as Frito-Lay, Pizza Hut, Taco Bell, and
KFC.

Answers and Solutions: 4 - 3

 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

4-1 DSO = 20 days; ADS = $20,000; AR = ?

AR
DSO =
S
365
AR
20 =
$20,000
AR = $400,000.

4-2 A/E = 2.5; D/A = ?

 
D  1 
= 1 - 
A  A 
 
 E 
D  1 
= 1 - 
A  2.5 
D
= 1 – 0.40 = 0.60 = 60%
A
 
D  1 
= 1 - 
A  A
 
 E 
D  1 
= 1 - 
A  2.5 
D
= 0.40 = 40%.
A

4-3 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE =

$6,000,000,000; Shares outstanding = 800,000,000; P0 = $32; M/B = ?
$6,000 ,000,000
Book value = 800,000,000
= $7.50.

$75.00
M/B = = 10.
$7.50

Answers and Solutions: 4 - 4

4-4 EPS = $1.50; CFPS = $3.00; P/CF = 8.0; P/E = ?
P/CF = 8.0
P/$3.00 = 8.0
P = $24.00.
P/E = $24.00/$1.50 = 16.0.

4-5 PM = 3%; EM = 2.0; Sales = $100,000,000; Assets = $50,000,000; ROE = ?

ROE = PM  TATO  EM
= NI/S  S/TA  A/E
= 3%  $100,000,00/$50,000,000  2
= 12%.

4-6 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; A/E = ?

ROA = NI/A; PM = NI/S; ROE = NI/E

ROA = PM  S/TA
NI/A = NI/S  S/TA
10% = 2%  S/TA
S/TA = 5.

ROE = PM  S/TA  TA/E

NI/E = NI/S  S/TA  TA/E
15% = 2%  5  TA/E
15% = 10%  TA/E
TA/E = 1.5.

Answers and Solutions: 4 - 5

 CA CA - I
4-7 CA = $3,000,000; = 1.5; = 1.0;
CL CL

CL = ?; I = ?

CA
= 1.5
CL
$3,000,000
= 1.5
CL
1.5 CL = $3,000,000
CL = $2,000,000.

CA - I nv
= 1.0
CL

$3,000,000 - I nv
= 1.0
$2,000,000
$3,000,000 - I nv = $2,000,000
I nv = $1,000,000.
CA - I nv
= 1.0
CL
$3,000,000 - I nv
= 1.0
$2,000,000
$3,000,000 - I nv = $2,000,000
I nv = $1,000,000.

Answers and Solutions: 4 - 6

4-8 We are given ROA = 3% and Sales/Total assets = 1.5.

From Du Pont equation: ROA = Profit margin  Total assets turnover

3% = Profit margin (1.5)
Profit margin = 3%/1.5 = 2%.

We can also calculate the company’s debt ratio in a similar manner, given the facts of the
problem. We are given ROA(NI/A) and ROE(NI/E); if we use the reciprocal of ROE we
have the following equation:

E NI E D E
= _ and =1- , so
A A NI A A
E 1
= 3% _
A 0.05
E
= 60% .
A
D
= 1 - 0.60 = 0.40 = 40% .
A

Alternatively,

ROE = ROA  EM
5% = 3%  EM
EM = 5%/3% = 5/3 = TA/E.

Take reciprocal:

E/TA = 3/5 = 60%;

therefore,

D/A = 1 - 0.60 = 0.40 = 40%.

Thus, the firm’s profit margin = 2% and its debt ratio = 40%.

Answers and Solutions: 4 - 7

 $1,312,500
4-9 Present current ratio = $525,000 = 2.5.

$1,312,500 +  NP
Minimum current ratio = $525,000 +  NP = 2.0.

$1,312,500 + ∆NP = $1,050,000 + 2∆NP

∆NP = $262,500.

Short-term debt can increase by a maximum of $262,500 without violating a 2 to 1

current ratio, assuming that the entire increase in notes payable is used to increase current
assets. Since we assumed that the additional funds would be used to increase inventory,
the inventory account will increase to $637,500, and current assets will total $1,575,000.

Quick ratio = ($1,575,000 - $637,500)/$787,500 = $937,500/$787,500 = 1.19.

4-10 TIE = EBIT/INT, so find EBIT and INT.

Interest = $500,000  0.1 = $50,000.
Net income = $2,000,000  0.05 = $100,000.
Pre-tax income = $100,000/(1 - T) = $100,000/0.7 = $142,857.

EBIT = $142,857 + $50,000 = $192,857.

TIE = $192,857/$50,000 = 3.86.

Answers and Solutions: 4 - 8

4-11 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000

= $90,000

3. Common stock =- Debt - Retained earnings

= $300,000 - $150,000 - $97,500 = $52,500.

4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.

5. Inventory = Sales/5 = $450,000/5 = $90,000.

6. Accounts receivable = (Sales/365)(DSO) = ($450,000/365)(36.5)

= $45,000.

7. Cash + Accounts receivable = (0.80)(Accounts payable)

Cash + $45,000 = (0.80)($90,000)
Cash = $72,000 - $45,000 = $27,000.

8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)

= $300,000 - ($27,000 + $45,000 + $90,000) = $138,000.

9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75)

= $337,500.

Answers and Solutions: 4 - 9

 Current assets $810,000
4-12 1. = 3.0 = 3.0
Current liabilities Current liabilities

Current liabilities = $270,000.

Current assets - Inventories $810,000 - Inventories

2. = 1.4 $270,000
= 1.4
Current liabilities

Inventories = $432,000.
Current Marketable Accounts
3. assets
= Cash +
Securities
+
receivable
+ Inventories

$810,000 = $120,000 + Accounts receivable + $432,000

Accounts receivable = $258,000.

Sales Sales
4. Inventory
= 6.0 $432,000
= 6.0

Sales = $2,592,000.

Accounts receivable $258,000

5. DSO = = $2,592,000/ 365 = 36.33 days.
Sales/ 365

Answers and Solutions: 4 - 10

4-13 a. (Dollar amounts in thousands.)
Industry
Firm Average

Current assets $655,000

= = 1.98
Current liabilities $330,000
2.0

Accounts receivable $336,000

DSO = = $4,404.11 = 76 days 35 days
Sales/ 365

Sales $1,607,500
= = 6.66 6.7
Inventory $241,500

Sales $1,607,500
= $292,500
= 5.50 12.1
Fixed assets

Sales $1,607,500
= $947,500
= 1.70 3.0
Total assets

Net income $27,300

= $1,607,500 = 1.7% 1.2%
Sales

Net income $27,300

= $947,500 = 2.9% 3.6%
Total assets

Industry
Firm Average

Net income $27,300

Common equity
= $361,000 = 7.6% 9.0%

Total debt $586,500

= = 61.9% 60.0%
Total assets $947,500

Answers and Solutions: 4 - 11

 b. For the firm,

$947,500
ROE = PM  T.A. turnover  EM = 1.7%  1.7  $361,000 = 7.6%.
For the industry, ROE = 1.2%  3  2.5 = 9%.

Note: To find the industry ratio of assets to common equity, recognize that 1 - (total
debt/total assets) = common equity/total assets. So, common equity/total assets =
40%, and 1/0.40 = 2.5 = total assets/common equity.

c. The firm’s days sales outstanding is more than twice as long as the industry average,
indicating that the firm should tighten credit or enforce a more stringent collection
policy. The total assets turnover ratio is well below the industry average so sales
should be increased, assets decreased, or both. While the company’s profit margin is
higher than the industry average, its other profitability ratios are low compared to the
industry--net income should be higher given the amount of equity and assets.
However, the company seems to be in an average liquidity position and financial
leverage is similar to others in the industry.

d. If 2007 represents a period of supernormal growth for the firm, ratios based on this
year will be distorted and a comparison between them and industry averages will
have little meaning. Potential investors who look only at 2006 ratios will be misled,
and a return to normal conditions in 2008 could hurt the firm’s stock price.

Answers and Solutions: 4 - 12

4-14 a. Here are the firm’s base case ratios and other data as compared to the industry:

Firm Industry Comment

Quick 0.8 1.0 Weak
Current 2.3 2.7 Weak
Inventory turnover 4.8 7.0 Poor
Days sales outstanding 37 days 32 days Poor
Fixed assets turnover 10.0 13.0 Poor
Total assets turnover 2.3 2.6 Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1 18.2 Bad
Debt ratio 54.8 50.0 High
Profit margin on sales 2.5 3.5 Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0 6.0 Poor
P/CF ratio 2.0 3.5 Poor
M/B ratio 0.65 n.a. --

The firm appears to be badly managed--all of its ratios are worse than the industry
averages, and the result is low earnings, a low P/E, P/CF ratio, a low stock price, and
a low M/B ratio. The company needs to do something to improve.

b. A decrease in the inventory level would improve the inventory turnover, total assets
turnover, and ROA, all of which are too low. It would have some impact on the
current ratio, but it is difficult to say precisely how that ratio would be affected. If the
lower inventory level allowed the company to reduce its current liabilities, then the
current ratio would improve. The lower cost of goods sold would improve all of the
profitability ratios and, if dividends were not increased, would lower the debt ratio
through increased retained earnings. All of this should lead to a higher market/book
ratio and a higher stock price.

Answers and Solutions: 4 - 13

 SOLUTION TO SPREADSHEET PROBLEM

4-152 The detailed solution for the problem is available is in the file Solution to FM12 CF3
Ch 04 P152 Build a Model.xls and is available on the instructor’s side of at the
textbook’s web site.

Answers and Solutions: 4 - 14

 MINI CASE

The first part of the case, presented in Chapter 3, discussed the situation that Computron
Industries was in after an expansion program. Thus far, sales have not been up to the
forecasted level, costs have been higher than were projected, and a large loss occurred in
20087, rather than the expected profit. As a result, its managers, directors, and investors
are concerned about the firm’s survival.
Donna Jamison was brought in as assistant to Fred Campo, Computron’s chairman,
who had the task of getting the company back into a sound financial position. Computron’s
20076 and 20087 balance sheets and income statements, together with projections for
20098, are shown in the following tables. Also, the tables show the 20076 and 20087
financial ratios, along with industry average data. The 20098 projected financial statement
data represent Jamison’s and Campo’s best guess for 20098 results, assuming that some
new financing is arranged to get the company “over the hump.”
Jamison examined monthly data for 20087 (not given in the case), and she detected an
improving pattern during the year. Monthly sales were rising, costs were falling, and large
losses in the early months had turned to a small profit by December. Thus, the annual data
looked somewhat worse than final monthly data. Also, it appears to be taking longer for
the advertising program to get the message across, for the new sales offices to generate
sales, and for the new manufacturing facilities to operate efficiently. In other words, the
lags between spending money and deriving benefits were longer than Computron’s
managers had anticipated. For these reasons, Jamison and Campo see hope for the
company--provided it can survive in the short run.
Jamison must prepare an analysis of where the company is now, what it must do to
regain its financial health, and what actions should be taken. Your assignment is to help
her answer the following questions. Provide clear explanations, not yes or no answers.

Mini Case: 4 - 15
Balance Sheets

Assets 20076 20087 20098e

Cash $ 9,000 $ $
7,282 14,000
Short-Term Investments. 48,600 20,000 71,632
Accounts Receivable 351,200 632,160 878,000
Inventories 715,200 1,287,360 1,716,480
Total Current Assets $ 1,124,000 $ $
1,946,802 2,680,112
Gross Fixed Assets 491,000 1,202,950 1,220,000
Less: Accumulated Depreciation 146,200 263,160 383,160
Net Fixed Assets $ 344,800 $ $
939,790 836,840
Total Assets $ 1,468,800 $ $
2,886,592 3,516,952

Liabilities And Equity 20076 20087 20098e

Accounts Payable $ 145,600 $ $
324,000 359,800
Notes Payable 200,000 720,000 300,000
Accruals 136,000 284,960 380,000
Total Current Liabilities $ 481,600 $ $
1,328,960 1,039,800
Long-Term Debt 323,432 1,000,000 500,000
Common Stock (100,000 Shares) 460,000 460,000 1,680,936
Retained Earnings 203,768 97,632 296,216
Total Equity $ 663,768 $ $
557,632 1,977,152
Total Liabilities And Equity $ 1,468,800 $ $
2,886,592 3,516,952

Mini Case: 4 - 16
Income Statements
20076 20087 20098e
Sales $ 3,432,000 $ 5,834,400 $
7,035,600
Cost Of Goods Sold 2,864,000 4,980,000 5,800,000
Other Expenses 340,000 720,000 612,960
Depreciation 18,900 116,960 120,000
Total Operating Costs $ 3,222,900 $ 5,816,960 $
6,532,960
EBIT $ 209,100 $ 17,440 $
502,640
Interest Expense 62,500 176,000 80,000
EBT $ 146,600 $ $
(158,560) 422,640
Taxes (40%) 58,640 (63,424) 169,056
Net Income $ 87,960 $ $
(95,136) 253,584

Other Data 20076 20087 20098e

Stock Price $ 8.50 $ 6.00 $
12.17
Shares Outstanding 100,000 100,000 250,000
EPS $ 0.880 $ $
(0.951) 1.014
DPS $ 0.220 $ 0.110 $
0.220
Tax Rate 40% 40% 40%
Book Value Per Share $ 6.638 $ 5.576 $
7.909
Lease Payments $ 40,000 $ 40,000 $
40,000

Mini Case: 4 - 17
Ratio Analysis 20076 20087 20098e Industry Average
Current 2.3 1.5 2.58 2.7
Quick 0.8 0.5 0.93 1.0
Inventory Turnover 4.8 4.5 4.10 6.1
Days Sales Outstanding 37.4 39. 45.5 32.0
5
Fixed Assets Turnover 10.0 6. 8.4 7.0
2 1
Total Assets Turnover 2.3 2. 2.0 2.5
0 0
Debt Ratio 54.8% 80.7% 43.8% 50.0%
TIE 3.3 0.1 6.3 6.2
EBITDA Coverage 2.6 0.8 5.5 8.0
Profit Margin 2.6% -1.6% 3.6% 3.6%
Basic Earning Power 14.2% 0.6% 14.3% 17.8%
ROA 6.0% -3.3% 7.2% 9.0%
ROE 13.3% -17.1% 12.8% 17.9%
Price/Earnings (P/E) 9.7 -6.3 12.0 16.2
Price/Cash Flow 8.0 27.5 8.1 7.6
Market/Book 1.3 1.1 1.5 2.9

a. Why are ratios useful? What are the five major categories of ratios?

Answer: Ratios are used by managers to help improve the firm’s performance, by lenders to
help evaluate the firm’s likelihood of repaying debts, and by stockholders to help
forecast future earnings and dividends. The five major categories of ratios are:
liquidity, asset management, debt management, profitability, and market value.

Mini Case: 4 - 18
b. Calculate the 20098 current and quick ratios based on the projected balance
sheet and income statement data. What can you say about the company’s
liquidity position in 20076, 20087, and as projected for 20098? We often think of
ratios as being useful (1) to managers to help run the business, (2) to bankers for
credit analysis, and (3) to stockholders for stock valuation. Would these
different types of analysts have an equal interest in the liquidity ratios?

Answer: Current Ratio098= Current Assets/Current Liabilities

= $2,680,112/$1,039,800 = 2.58.

Quick Ratio098 = (Current Assets – Inventory)/Current Liabilities

= ($2,680,112 - $1,716,480)/$1,039,800 = 0.93.

The company’s current and quick ratios are higher relative to its 20076 current
and quick ratios; they have improved from their 20087 levels. Both ratios are below
the industry average, however.

c. Calculate the 20098 inventory turnover, days sales outstanding (DSO), fixed
assets turnover, and total assets turnover. How does Computron’s utilization of
assets stack up against other firms in its industry?

Answer: Inventory Turnover098 = Sales/Inventory

= $7,035,600/$1,716,480 = 4.10.

DSO098 = Receivables/(Sales/365)
= $878,000/($7,035,600/365) = 45.5 Days.

Fixed Assets Turnover098 = Sales/Net Fixed Assets

= $7,035,600/$836,840 = 8.41.

Total Assets Turnover098 = Sales/Total Assets

= $7,035,600/$3,516,952 = 2.0.

The firm’s inventory turnover ratio has been steadily declining, while its days
sales outstanding has been steadily increasing. While the firm’s fixed assets turnover
ratio is below its 20076 level, it is above the 20087 level. The firm’s total assets
turnover ratio is below its 20076 level and equal to its 20087 level.
The firm’s inventory turnover and total assets turnover are below the industry
average. The firm’s days sales outstanding is above the industry average (which is
bad); however, the firm’s fixed assets turnover is above the industry average. (This
might be due to the fact that Computron is an older firm than most other firms in the

Mini Case: 4 - 19
 industry, in which case, its fixed assets are older and thus have been depreciated
more, or that Computron’s cost of fixed assets were lower than most firms in the
industry.)

d. Calculate the 20098 debt, times-interest-earned, and EBITDA coverage ratios.

How does Computron compare with the industry with respect to financial
leverage? What can you conclude from these ratios?

Answer: Debt Ratio098 = Total Liabilities/Total Assets

= ($1,039,800 + $500,000)/$3,516,952 = 43.8%.
Tie098 = EBIT/Interest = $502,640/$80,000 = 6.3.

 Lease   Loan Lease 

EBITDA Coverage088 =  EBITDA  Payments  /  Interest  Repayments  Payments 
   
= ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5.

The firm’s debt ratio is much improved from 20087, and is still lower than its
20076 level and the industry average. The firm’s TIE and EBITDA coverage ratios
are much improved from their 20076 and 20087 levels. The firm’s TIE is better than
the industry average, but the EBITDA coverage is lower, reflecting the firm’s higher
lease obligations.

e. Calculate the 20098 profit margin, basic earning power (BEP), return on assets
(ROA), and return on equity (ROE). What can you say about these ratios?

Answer: Profit Margin098 = Net Income/Sales = $253,584/$7,035,600 = 3.6%.

Basic Earning Power098 = EBIT/Total Assets = $502,640/$3,516,952

= 14.3%.

Mini Case: 4 - 20
 ROA098 = Net Income/Total Assets = $253,584/$3,516,952 = 7.2%.

ROE098 = Net Income/Common Equity = $253,584/$1,977,152 = 12.8%.

The firm’s profit margin is above 20076 and 20087 levels and is at the industry
average. The basic earning power, ROA, and ROE ratios are above both 20076 and
20087 levels, but below the industry average due to poor asset utilization.

f. Calculate the 20098 price/earnings ratio, price/cash flow ratios, and

market/book ratio. Do these ratios indicate that investors are expected to have a
high or low opinion of the company?

Answer: EPS = Net Income/Shares Outstanding = $253,584/250,000 = $1.0143.

Price/Earnings098 = Price Per Share/Earnings Per Share

= $12.17/$1.0143 = 12.0.

Check: Price = EPS  P/E = $1.0143(12) = $12.17.

Cash Flow/Share098 = (NI + DEP)/Shares

= ($253,584 + $120,000)/250,000
= $1.49.

Price/Cash Flow = $12.17/$1.49 = 8.2.

BVPS = Common Equity/Shares Outstanding

= $1,977,152/250,000 = $7.91.

Market/Book = Market Price Per Share/Book Value Per Share

= $12.17/$7.91 = 1.54x.

Both the P/E ratio and BVPS are above the 20076 and 20087 levels but below the
industry average.

g. Perform a common size analysis and percent change analysis. What do these
analyses tell you about Computron?

Answer: For the common size balance sheets, divide all items in a year by the total assets for
that year. For the common size income statements, divide all items in a year by the
sales in that year.

Mini Case: 4 - 21
 Common Size Balance Sheets
Assets
20076 20087 20098e Ind.
Cash 0.6% 0.3% 0.4% 0.3%
Short Term Investments 3.3% 0.7% 2.0% 0.3%
Accounts Receivable 23.9% 21.9% 25.0% 22.4%
Inventories 48.7% 44.6% 48.8% 41.2%
Total Current Assets 76.5% 67.4% 76.2% 64.1%
Gross Fixed Assets 33.4% 41.7% 34.7% 53.9%
Less Accumulated Depreciation 10.0% 9.1% 10.9% 18.0%
Net Fixed Assets 23.5% 32.6% 23.8% 35.9%
Total Assets 100.0% 100.0 100.0 100.0%
% %

Liabilities And Equity 20076 20087 20098e Ind.

Accounts Payable 9.9% 11.2% 10.2% 11.9%
Notes Payable 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total Current Liabilities 32.8% 46.0% 29.6% 23.7%
Long-Term Debt 22.0% 34.6% 14.2% 26.3%
Common Stock (100,000 Shares) 31.3% 15.9% 47.8% 20.0%
Retained Earnings 13.9% 3.4% 8.4% 30.0%
Total Equity 45.2% 19.3% 56.2% 50.0%
Total Liabilities And Equity 100.0% 100.0 100.0 100.0%
% %

Common Size Income Statement 20076 20087 20098e Ind.

Sales 100.0% 100.0 100.0 100.0%
% %
Cost Of Goods Sold 83.4% 85.4% 82.4% 84.5%
Other Expenses 9.9% 12.3% 8.7% 4.4%
Depreciation 0.6% 2.0% 1.7% 4.0%
Total Operating Costs 93.9% 99.7% 92.9% 92.9%
EBIT 6.1% 0.3% 7.1% 7.1%
Interest Expense 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes (40%) 1.7% -1.1% 2.4% 2.4%
Net Income 2.6% -1.6% 3.6% 3.6%

Computron has higher proportion of inventory and current assets than

industry. Computron has slightly more equity (which means less debt) than industry.

Mini Case: 4 - 22
Computron has more short-term debt than industry, but less long-term debt than
industry. Computron has lower COGS than industry, but higher other expenses.
Result is that Computron has similar EBIT as industry.

Mini Case: 4 - 23
 For the percent change analysis, divide all items in a row by the value in the first
year of the analysis.
Percent Change Balance Sheets
Assets
2007 20087 20098e
6
Cash 0.0% -19.1% 55.6%
Short Term Investments 0.0% -58.8% 47.4%
Accounts Receivable 0.0% 80.0% 150.0
%
Inventories 0.0% 80.0% 140.0
%
Total Current Assets 0.0% 73.2% 138.4
%
Gross Fixed Assets 0.0% 145.0 148.5
% %
Less Accumulated Depreciation 0.0% 80.0% 162.1
%
Net Fixed Assets 0.0% 172.6 142.7
% %
Total Assets 0.0% 96.5% 139.4
%

Liabilities And Equity 2007 20087 20098e

6
Accounts Payable 0.0% 122.5 147.1
% %
Notes Payable 0.0% 260.0 50.0%
%
Accruals 0.0% 109.5 179.4
% %
Total Current Liabilities 0.0% 175.9 115.9
% %
Long-Term Debt 0.0% 209.2 54.6%
%
Common Stock (100,000 Shares) 0.0% 0.0% 265.4
%
Retained Earnings 0.0% -52.1% 45.4%
Total Equity 0.0% -16.0% 197.9
%
Total Liabilities And Equity 0.0% 96.5% 139.4
%

Mini Case: 4 - 24
 Percent Change Income Statement 2007 20087 20098e
6
Sales 0.0% 70.0% 105.0
%
Cost Of Goods Sold 0.0% 73.9% 102.5
%
Other Expenses 0.0% 111.8% 80.3%
Depreciation 0.0% 518.8% 534.9
%
Total Operating Costs 0.0% 80.5% 102.7
%
EBIT 0.0% -91.7% 140.4
%
Interest Expense 0.0% 181.6% 28.0%
EBT 0.0% - 188.3
208.2% %
Taxes (40%) 0.0% - 188.3
208.2% %
Net Income 0.0% - 188.3
208.2% %

We see that 20098 sales grew 105% from 20076, and that NI grew 188% from
20076. So Computron has become more profitable. We see that total assets grew at
a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains
a problem.

Mini Case: 4 - 25
h. Use the extended Du Pont equation to provide a summary and overview of
Computron’s financial condition as projected for 20098. What are the firm’s
major strengths and weaknesses?

Profit Total Assets Equity

Answer: Du Pont Equation = Margin
 Turnover
 Multiplier
= 3.6%  2.0  ($3,516,952/$1,977,152)
= 3.6%  2.0  1.8 = 13.0%.

Strengths: The firm’s fixed assets turnover was above the industry average.
However, if the firm’s assets were older than other firms in its industry this could
possibly account for the higher ratio. (Computron’s fixed assets would have a lower
historical cost and would have been depreciated for longer periods of time.) The
firm’s profit margin is slightly above the industry average, despite its higher debt
ratio. This would indicate that the firm has kept costs down, but, again, this could be
related to lower depreciation costs.

Weaknesses: The firm’s liquidity ratios are low; most of its asset management ratios
are poor (except fixed assets turnover); its debt management ratios are poor, most of
its profitability ratios are low (except profit margin); and its market value ratios are
low.

i. What are some potential problems and limitations of financial ratio analysis?

Answer: Some potential problems are listed below:

1. Comparison with industry averages is difficult if the firm operates many different
divisions.

2. Different operating and accounting practices distort comparisons.

3. Sometimes hard to tell if a ratio is “good” or “bad.”

4. Difficult to tell whether company is, on balance, in a strong or weak position.

5. “Average” performance is not necessarily good.

6. Seasonal factors can distort ratios.

7. “Window dressing” techniques can make statements and ratios look better.

Mini Case: 4 - 26
j. What are some qualitative factors analysts should consider when evaluating a
company’s likely future financial performance?

Answer: Top analysts recognize that certain qualitative factors must be considered when
evaluating a company. These factors, as summarized by the American Association
Of Individual Investors (AAII), are as follows:

1. Are the company’s revenues tied to one key customer?

2. To what extent are the company’s revenues tied to one key product?

3. To what extent does the company rely on a single supplier?

4. What percentage of the company’s business is generated overseas?

5. Competition

6. Future prospects

7. Legal and regulatory environment

Mini Case: 4 - 27