ANALYSIS OF FINANCIAL STATEMENTS(Ratio)

FIN 301 SHEIKH ALI ZULFIKAR

LEARNING OBJECTIVES
Explain why ratio analysis is usually the first step in the analysis of a companys financial statements. List the five groups of ratios, specify which ratios belong in each group, and explain what information each group gives us about the firms financial position. State what trend analysis is, and why it is important. Describe how the Du Pont equation is used, and how it may be modified to include the effect of financial leverage. Explain benchmarking and its purpose. List several limitations of ratio analysis. Identify some of the problems with ROE that can arise when firms use it as a sole measure of performance. Identify some of the qualitative factors that must be considered when evaluating a companys financial performance.

OVERVIEW
Financial analysis is designed to determine the relative strengths and weaknesses of a company. Investors need this information to estimate both future cash flows from the firm and the riskiness of those cash flows. Financial managers need the information provided by analysis both to evaluate the firms past performance and to map future plans. Financial analysis concentrates on financial statement analysis, which highlights the key aspects of a firms operations. Financial statement analysis involves a study of the relationships between income statement and balance sheet accounts, how these relationships change over time (trend analysis), and how a particular firm compares

ANALYSIS OF FINANCIAL STATEMENTS 3-2

with other firms in its industry (benchmarking). Although financial analysis has limitations, when used with care and

judgment, it can provide some very useful insights into a companys operations.

OUTLINE
Financial statements are used to help predict the firms future earnings and divi dends. From an investors standpoint, predicting the future is what financial state ment analysis is all about. From managements standpoint, financial statement analysis is useful both to help anticipate future conditions and, more important, as a starting point for planning actions that will influence the future course of events. Financial ratios are designed to help one evaluate a firms financial statements. The burden of debt, and the companys ability to repay, can be best evaluated (1) by comparing the companys debt to its assets and (2) by comparing the interest it must pay to the income it has available for payment of interest. Such comparisons are made by ratio analysis. A liquid asset is an asset that can be converted to cash quickly without having to reduce the assets price very much. Liquidity ratios are used to measure a firms ability to meet its current obligations as they come due. One of the most commonly used liquidity ratios is the current ratio. The current ratio measures the extent to which current liabilities are covered by current assets. It is determined by dividing current assets by current liabilities. It is the most commonly used measure of short-term solvency. Asset management ratios measure how effectively a firm is managing its assets and whether the level of those assets is properly related to the level of operations as measured by sales. The inventory turnover ratio is defined as sales divided by inventories. It is often necessary to use average inventories rather than year-end inventories, especially if a firms business is highly seasonal, or if there has been a strong upward or downward sales trend during the year. Days sales outstanding (DSO), also called the average collection period (ACP), is used to appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily sales to find the number of days sales tied up in receivables. The DSO represents the average length of time that the firm must wait after making a sale before receiving cash.

ANALYSIS OF FINANCIAL STATEMENTS 3-3

The DSO can also be evaluated by comparison with the terms on which the firm sells its goods. If the trend in DSO over the past few years has been rising, but the credit policy has not been changed, this would be strong evidence that steps should be taken to expedite the collection of accounts receivable. The fixed assets turnover ratio is the ratio of sales to net fixed assets. It measures how effectively the firm uses its plant and equipment. A potential problem can exist when interpreting the fixed assets turnover ratio of a firm with older, lower-cost fixed assets compared to one with recently acquired, higher-cost fixed assets. Financial analysts recognize that a problem exists and deal with it judgmentally. The total assets turnover ratio is calculated by dividing sales by total assets. It measures the utilization, or turnover, of all the firms assets. Debt management ratios measure the extent to which a firm is using debt financing, or financial leverage, and the degree of safety afforded to creditors. Financial leverage has three important implications: (1) By raising funds through debt, stockholders can maintain control of a firm while limiting their investment. (2) Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so if the stockholders have provided only a small proportion of the total financing, the firms risks are borne mainly by its creditors. (3) If the firm earns more on investments financed with borrowed funds than it pays in interest, the return on the owners capital is magnified, or leveraged. Firms with relatively high debt ratios have higher expected returns when the economy is normal, but they are exposed to risk of loss when the economy goes into a recession. Firms with low debt ratios are less risky, but also forgo the opportunity to leverage up their return on equity. Decisions about the use of debt require firms to balance higher expected returns against increased risk. Analysts use two procedures to examine the firms debt: (1) They check the balance sheet to determine the extent to which borrowed funds have been used to finance assets, and (2) they review the income statement to see the extent to which fixed charges are covered by operating profits. The debt ratio, or ratio of total debt to total assets, measures the percentage of funds provided by creditors. Total debt includes both current liabilities and long-term debt. The lower the ratio, the greater the protection afforded creditors in the event of liquidation.

ANALYSIS OF FINANCIAL STATEMENTS 3-4

Stockholders, on the other hand, may want more leverage because it magnifies expected earnings. A debt ratio that exceeds the industry average raises a red flag and may make it costly for a firm to borrow additional funds without first raising more equity capital. The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and taxes (EBIT) by the interest charges. The TIE measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Note that EBIT, rather than net income, is used in the numerator. Because interest is paid with pre-tax dollars, the firms ability to pay current interest is not affected by taxes. This ratio has two shortcomings: (1) Interest is not the only fixed financial charge. (2) EBIT does not represent all the cash flow available to service debt, especially if a firm has high depreciation and/or amortization charges. To account for the deficiencies of the TIE ratio, bankers and others have developed the EBITDA coverage ratio. It is calculated as EBITDA plus lease payments divided by the sum of interest, principal repayments, and lease payments. The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks, which rarely make loans (except real estate-backed loans) for longer than about five years. Over a relatively short period, depreciation-generated funds can be used to service debt. Over a longer time, depreciation-generated funds must be reinvested to maintain the plant and equipment or else the company cannot remain in business. Banks and other relatively short-term lenders focus on the EDITDA coverage ratio, whereas long-term bondholders focus on the TIE ratio. Profitability ratios show the combined effects of liquidity, asset management, and debt on operating results. The profit margin on sales is calculated by dividing net income by sales. It gives the profit per dollar of sales. The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes (EBIT) by total assets. It shows the raw earning power of the firms assets, before the influence of taxes and leverage. It is useful for comparing firms with different tax situations and different degrees of financial leverage. The return on total assets (ROA) is the ratio of net income to total assets.

ANALYSIS OF FINANCIAL STATEMENTS 3-5

It measures the return on all the firms assets after interest and taxes. The return on common equity (ROE) measures the rate of return on the stockholders investment. It is equal to net income divided by common equity. Stockholders invest to get a return on their money, and this ratio tells how well they are doing in an accounting sense. Market value ratios relate the firms stock price to its earnings, cash flow, and book value per share, and thus give management an indication of what investors think of the companys past performance and future prospects. If the liquidity, asset management, debt management, and profitability ratios all look good, then the market value ratios will be high, and the stock price will probably be as high as can be expected. The price/earnings (P/E) ratio, or price per share divided by earnings per share, shows how much investors are willing to pay per dollar of reported profits. P/E ratios are higher for firms with strong growth prospects, other things held constant, but they are lower for riskier firms. The price/cash flow ratio is the ratio of price per share divided by cash flow per share. It shows the dollar amount investors will pay for $1 of cash flow. The market/book (M/B) ratio, defined as market price per share divided by book value per share, gives another indication of how investors regard the company. Higher M/B ratios are generally associated with firms with relatively high rates of return on common equity. An M/B ratio greater than 1.0 means that investors are willing to pay more for stocks than their accounting book values. It is important to analyze trends in ratios as well as their absolute levels. Trend analysis can provide clues as to whether the firms financial situation is likely to improve or to deteriorate. The Extended Du Pont Equation shows how return on equity is affected by assets turnover, profit margin, and leverage. This measure was developed by Du Pont managers for evaluating performance and analyzing ways of improving performance. The profit margin times the total assets turnover is called the Du Pont Equation. This equation gives the rate of return on assets (ROA): ROA = Profit margin Total assets turnover. The ROA times the equity multiplier (total assets divided by common equity) yields the return on equity (ROE). This equation is referred to as the Extended Du Pont Equation: ROE = Profit margin Total assets turnover Equity multiplier.

ANALYSIS OF FINANCIAL STATEMENTS 3-6

If a company is financed only with common equity, the return on assets (ROA) and the return on equity (ROE) are the same because total assets will equal common equity. This equality holds only if the company uses no debt. Ratio analysis involves comparisons because a companys ratios are compared with those of other firms in the same industry, that is, to industry average figures. Comparative ratios are available from a number of sources including ValueLine, Dun & Bradstreet, Robert Morris Associates, and the U. S. Commerce Department. Benchmarking is the process of comparing the ratios of a particular company with those of a smaller group of benchmark companies, rather than with the entire industry. Benchmarking makes it easy for a firm to see exactly where the company stands relative to its competition. There are some inherent problems and limitations to ratio analysis that necessitate care and judgment. Ratio analysis conducted in a mechanical, unthinking manner is dangerous, but used intelligently and with good judgment, it can provide useful insights into a firms operations. Financial ratios are used by three main groups: Managers, who employ ratios to help analyze, control, and thus improve their firms operations. Credit analysts, such as bank loan officers or bond rating analysts, who analyze ratios to help ascertain a companys ability to pay its debts. Stock analysts, who are interested in a companys efficiency, risk, and growth prospects. Ratios are often not useful for analyzing the operations of large firms that operate in many different industries because comparative ratios are not meaningful. The use of industry averages may not provide a very challenging target for high-level performance. Inflation affects depreciation charges, inventory costs, and therefore, the value of both balance sheet items and net income. For this reason, the analysis of a firm over time, or a comparative analysis of firms of different ages, can be misleading. Ratios may be distorted by seasonal factors, or manipulated by management to give the impression of a sound financial condition (window dressing techniques). Different operating policies and accounting practices, such as the decision to lease rather than to buy equipment, can distort comparisons.

ANALYSIS OF FINANCIAL STATEMENTS 3-7

Many ratios can be interpreted in different ways, and whether a particular ratio is good or bad should be based upon a complete financial analysis rather than the level of a single ratio at a single point in time. Despite its widespread use and the fact that ROE and shareholder wealth are often highly correlated, some problems can arise when firms use ROE as the sole measure of performance. ROE does not consider risk. ROE does not consider the amount of invested capital. A projects return, risk, and size combine to determine its impact on shareholder value. To the extent that ROE focuses only on rate of return and ignores risk and size, increasing ROE may in some cases be inconsistent with increasing shareholder wealth. Alternative measures of performance have been developed, including Market Value Added (MVA) and Economic Value Added (EVA). While it is important to understand and interpret financial statements, sound financial analysis involves more than just calculating and interpreting numbers. Good analysts recognize that certain qualitative factors must be considered when evaluating a company. Some of these factors are: The extent to which the companys revenues are tied to one key customer. The extent to which the companys revenues are tied to one key product. The extent to which the company relies on a single supplier. The percentage of the companys business generated overseas. Competition. Future prospects. Legal and regulatory environment.

SELF-TEST QUESTIONS
Definitional 1. The current ratio is an example of a(n) ___________ ratio. It measures a firms ability to meet its _________ obligations. The days sales outstanding (DSO) ratio is found by dividing average sales per day into accounts ____________. The DSO is the length of time that a firm must wait after making a sale before it receives ______.

2.

ANALYSIS OF FINANCIAL STATEMENTS 3-8

3. 4.

Debt management ratios are used to evaluate a firms use of financial __________. The debt ratio, which is the ratio of _______ ______ to _______ ________, measures the percentage of funds supplied by creditors. The _______-__________-________ ratio is calculated by dividing earnings before interest and taxes by the amount of interest charges. The combined effects of liquidity, asset management, and debt on operating results are measured by _______________ ratios. Dividing net income by sales gives the ________ ________ on sales. The _______/__________ ratio measures how much investors are willing to pay for each dollar of a firms reported profits. Firms with higher rates of return on stockholders equity tend to sell at relatively high ratios of ________ price to ______ value. Individual ratios are of little value in analyzing a companys financial conditi on. More important are the _______ of a ratio over time and the comparison of the companys ratios to __________ average ratios. The __________ ____ ______ __________ shows how return on equity is affected by total assets turnover, profit margin, and leverage. Return on assets is a function of two variables, the profit ________ and _______ ________ turnover. Analyzing a particular ratio over time for an individual firm is known as _______ analysis. The process of comparing a particular company with a smaller set of companies in the same industry is called ______________. Financial ratios are used by three main groups: (1) __________, who employ ratios to help analyze, control, and thus improve their firms operations; (2) ________ __________, who analyze ratios to help ascertain a companys ability to pay its debts; and (3) _______ __________, who are interested in a companys efficiency, risk, and growth prospects. The _______ ________ __________ ratio measures how effectively the firm uses its plant and equipment.

5.

6.

7. 8.

9.

10.

11.

12.

13. 14.

15.

16.

ANALYSIS OF FINANCIAL STATEMENTS 3-9

17. 18.

The _______ ________ __________ ratio measures the utilization of all the firms assets. Analysts use two procedures to examine the firms debt: (1) They check the _________ _______ to determine the extent to which borrowed funds have been used to finance assets, and, (2) they review the ________ ___________ to see the extent to which fixed charges are covered by operating profits. To account for the deficiencies of the TIE ratio, bankers have developed the ________ __________ ratio, which is most useful for relatively short-term lenders. The _______ _________ _______ ratio is useful for comparing firms with different tax situations and different degrees of financial leverage. If a company is financing only with common equity, the firms return on assets and return on equity will be _______. The _______/______ ______ ratio shows the dollar amount investors will pay for $1 of cash flow.

19.

20.

21.

22.

Conceptual 23. The equity multiplier can be expressed as 1 (Debt/Assets). a. True 24. b. False

A high current ratio is always a good indication of a well-managed liquidity position. a. True b. False

25.

International Appliances Inc. has a current ratio of 0.5. Which of the following actions would improve (increase) this ratio? a. b. c. d. e. Use cash to pay off current liabilities. Collect some of the current accounts receivable. Use cash to pay off some long-term debt. Purchase additional inventory on credit (accounts payable). Sell some of the existing inventory at cost.

26.

Refer to Self-Test Question 25. Assume that International Appliances has a current ratio of 1.2. Now, which of the following actions would improve (increase) this ratio? a. Use cash to pay off current liabilities. b. Collect some of the current accounts receivable.

ANALYSIS OF FINANCIAL STATEMENTS 3 - 10

c. Use cash to pay off some long-term debt. d. Purchase additional inventory on credit (accounts payable). e. Use cash to pay for some fixed assets. 27. Examining the ratios of a particular firm against the same measures for a small group of firms from the same industry, at a point in time, is an example of a. b. c. d. e. 28. Trend analysis. Benchmarking. Du Pont analysis. Simple ratio analysis. Industry analysis.

Which of the following statements is most correct? a. Having a high current ratio is always a good indication that a firm is managing its liquidity position well. b. A decline in the inventory turnover ratio suggests that the firms liquidity position is improving. c. If a firms times-interest-earned ratio is relatively high, then this is one indication that the firm should be able to meet its debt obligations. d. Since ROA measures the firms effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. e. If, through specific managerial actions, a firm has been able to increase its ROA, then, because of the fixed mathematical relationship between ROA and ROE, it must also have increased its ROE.

29.

Which of the following statements is most correct? a. Suppose two firms with the same amount of assets pay the same interest rate on their debt and earn the same rate of return on their assets and that ROA is positive. However, one firm has a higher debt ratio. Under these conditions, the firm with the higher debt ratio will also have a higher rate of return on common equity. b. One of the problems of ratio analysis is that the relationships are subject to manipulation. For example, we know that if we use some cash to pay off some of our current liabilities, the current ratio will always increase, especially if the current ratio is weak initially, for example, below 1.0. c. Generally, firms with high profit margins have high asset turnover ratios and firms with low profit margins have low turnover ratios; this result is exactly as predicted by the extended Du Pont equation. d. Firms A and B have identical earnings and identical dividend payout ratios. If Firm As growth rate is higher than Firm Bs, then Firm As P/E ratio must be greater than

ANALYSIS OF FINANCIAL STATEMENTS 3 - 11

Firm Bs P/E ratio. e. Each of the above statements is false.

SELF-TEST PROBLEMS
1. Info Technics Inc. has an equity multiplier of 2.75. The companys assets are financed with some combination of long-term debt and common equity. What is the companys debt ratio? a. 25.00% 2. b. 36.36% c. 52.48% d. 63.64% e. 75.00%

Refer to Self-Test Problem 1. What is the companys common equity ratio? a. 25.00% b. 36.36% c. 52.48% d. 63.64% e. 75.00%

3.

Cutler Enterprises has current assets equal to $4.5 million. The companys current ratio is 1.25. What is the firms level of current liabilities (in millions)? a. $0.8 b. $1.8 c. $2.4 d. $2.9 e. $3.6

4.

Jericho Motors has $4 billion in total assets. The other side of its balance sheet consists of $0.4 billion in current liabilities, $1.2 billion in long-term debt, and $2.4 billion in common equity. The company has 500 million shares of common stock outstanding, and its stock price is $25 per share. What is Jerichos market-to-book ratio? a. 2.00 b. 4.27 c. 5.21 d. 3.57 e. 1.42 Taylor Toys Inc. has $6 billion in assets, and its tax rate is 35 percent. The companys basic earning power (BEP) is 10 percent, and its return on assets (ROA) is 2.5 percent. What is Taylors times-interest-earned (TIE) ratio? a. 1.625 b. 2.000 c. 2.433 d. 2.750 e. 3.000

5.

(The following financial statements apply to the next six Self-Test Problems.) Roberts Manufacturing Balance Sheet December 31, 2002 (Dollars in Thousands) Cash Receivables Inventory $ 200 245 625 Accounts payable Notes payable Other current liabilities $ 205 425 115

ANALYSIS OF FINANCIAL STATEMENTS 3 - 12

Total current assets Net fixed assets Total assets

$1,070 1,200 $2,270

Total current liabilities Long-term debt Common equity Total liabilities and equity

$ 745 420 1,105 $2,270

Roberts Manufacturing Income Statement for Year Ended December 31, 2002 (Dollars in Thousands) Sales Cost of goods sold: Materials Labor Heat, light, and power Indirect labor Depreciation Gross profit Selling expenses General and administrative expenses Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Taxes (40%) Net income (NI) 6. Calculate the current ratio. a. 1.20 b. 1.33 c. 1.44 d. 1.51 e. 1.60 $2,400 $1,000 600 89 65 80

1,834 $ 566 175 216 $ 175 35 $ 140 56 $ 84

ANALYSIS OF FINANCIAL STATEMENTS 3 - 13

7.

Calculate the asset management ratios, that is, the inventory turnover ratio, fixed assets turnover, total assets turnover, and days sales outstanding. Assume a 365-day year. a. 3.84; 2.00; 1.06; 37.26 days b. 3.84; 2.00; 1.06; 35.25 days c. 3.84; 2.00; 1.06; 34.10 days d. 3.84; 2.00; 1.24; 34.10 days e. 3.84; 2.20; 1.48; 34.10 days

8.

Calculate the debt and times-interest-earned ratios. a. 0.39; 3.16 b. 0.39; 5.00 c. 0.51; 3.16 d. 0.51; 5.00 e. 0.73; 3.16

9.

Calculate the profitability ratios, that is, the profit margin on sales, return on total assets, return on common equity, and basic earning power of assets. a. 3.50%; 4.25%; 7.60%; 8.00% b. 3.50%; 3.70%; 7.60%; 7.71% c. 3.70%; 3.50%; 7.60%; 7.71% d. 3.70%; 3.50%; 8.00%; 8.00% e. 4.25%; 3.70%; 7.60%; 8.00%

10.

Calculate the market value ratios, that is, the price/earnings ratio, the price/cash flow ratio, and the market/book value ratio. Roberts had an average of 10,000 shares outstanding during 2002, and the stock price on December 31, 2002, was $40.00. a. 4.21; 2.00; 0.36 b. 3.20; 1.75; 1.54 c. 3.20; 2.44; 0.36 d. 4.76; 2.44; 1.54 e. 4.76; 2.44; 0.36

11.

Use the Extended Du Pont Equation to determine Roberts return on equity. a. 6.90% b. 7.24% c. 7.47% d. 7.60% e. 8.41%

12.

Lewis Inc. has sales of $2 million per year, all of which are credit sales. Its days sales outstanding is 42 days. What is its average accounts receivable balance? Assume a 365day year. a. $230,137 b. $266,667 c. $333,333 d. $350,000 e. $366,750

13.

Southeast Jewelers Inc. sells only on credit. Its days sales outstanding is 73 days, and its average accounts receivable balance is $500,000. What are its sales for the year? Assume a 365-day year. a. $1,500,000 b. $2,500,000 c. $2,000,000 d. $2,750,000 e. $3,000,000

14.

A firm has total interest charges of $20,000 per year, sales of $2 million, a tax rate of 40

ANALYSIS OF FINANCIAL STATEMENTS 3 - 14

percent, and a profit margin of 6 percent. What is the firms times-interest-earned ratio? a. 10 15. b. 11 c. 12 d. 13 e. 14

Refer to Self-Test Problem 14. What is the firms TIE, if its profit margin decreases to 3 percent and its interest charges double to $40,000 per year? a. 3.0 b. 2.5 c. 3.5 d. 4.2 e. 3.7

ANSWERS TO SELF-TEST QUESTIONS

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 23. 24. liquidity; current receivable; cash leverage total debt; total assets times-interest-earned profitability profit margin price/earnings market; book trend; industry Extended Du Pont Equation margin; total assets 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. trend benchmarking managers; credit analysts; stock analysts fixed assets turnover total assets turnover balance sheet; income statement EBITDA coverage basic earning power equal price/cash flow

b. 1 (Debt/Assets) = Equity/Assets. The equity multiplier is equal to Assets/Equity. b. Excess cash resulting from poor management could produce a high current ratio. Similarly, if accounts receivable are not collected promptly, this could also lead to a high current ratio. In addition, excess inventory which might include obsolete inventory could also lead to a high current ratio. d. This question is best analyzed using numbers. For example, assume current assets equal $50 and current liabilities equal $100; thus, the current ratio equals 0.5. For answer a, assume $5 in cash is used to pay off $5 in current liabilities. The new current ratio would be $45/$95 = 0.47. For answer d, assume a $10 purchase of inventory is made on credit (accounts payable). The new current ratio would be $60/$110 = 0.55, which is an increase over the old current ratio of 0.5 a. Again, this question is best analyzed using numbers. For example, assume current assets equal $120 and current liabilities equal $100; thus, the current ratio equals 1.2. For answer a, assume $5 in cash is used to pay off $5 in current liabilities. The new

25.

26.

ANALYSIS OF FINANCIAL STATEMENTS 3 - 15

current ratio would be $115/$95 = 1.21, which is an increase over the old current ratio of 1.2. For answer d, assume a $10 purchase of inventory is made on credit (accounts payable). The new current ratio would be $130/$110 = 1.18, which is a decrease over the old current ratio of 1.2. 27. b. The correct answer is benchmarking. A trend analysis compares the firms ratios over time, while a Du Pont analysis shows how return on equity is affected by assets turnover, profit margin, and leverage. c. Excess cash resulting from poor management could produce a high current ratio; thus statement a is false. A decline in the inventory turnover ratio suggests that either sales have decreased or inventory has increased, which suggests that the firms liquidity position is not improving; thus statement b is false. ROA = Net income/Total assets, and EBIT does not equal net income. Two firms with the same EBIT could have different financing and different tax rates resulting in different net incomes. Also, two firms with the same EBIT do not necessarily have the same total assets; thus, statement d is false. ROE = ROA Assets/Equity. If ROA increases because total assets decrease, then the equity multiplier decreases, and depending on which effect is greater, ROE may or may not increase; thus, statement e is false. Statement c is correct; the TIE ratio is used to measure whether the firm can meet its debt obligation, and a high TIE ratio would indicate this is so. a. Ratio analysis is subject to manipulation; however, if the current ratio is less than 1.0 and we use cash to pay off some current liabilities, the current ratio will decrease, not increase; thus statement b is false. Statement c is just the reverse of what actually occurs. Firms with high profit margins have low turnover ratios and vice versa. Statement d is false; it does not necessarily follow that if a firms growth rate is higher that its stock price will be higher. Statement a is correct. From the information given in statement a, one can determine that the two firms net incomes are equal; thus, the firm with the higher debt ratio (lower equity ratio) will indeed have a higher ROE.

28.

29.

SOLUTIONS TO SELF-TEST PROBLEMS

1. d. 2.75 = A/E E/A = 1/2.75 E/A = 36.36%. D/A = 1 E/A

ANALYSIS OF FINANCIAL STATEMENTS 3 - 16

= 1 36.36% = 63.64%. 2. 3. b. From Self-Test Problem #1 above, E/A = 36.36%. e. CA = $4.5 million; CA/CL = 1.25. $4.5/CL = 1.25 1.25(CL) = $4.5 CL = $3.6 million. 4. c. TA = $4,000,000,000; CL = $400,000,000; LT debt = $1,200,000,000; CE = $2,400,000,000; Shares outstanding = 500,000,000; P0 = $25; M/B = ? Book value =

$2,400,000,000 = $4.80. 500,000,000

M/B =

$25.00 = 5.2083 5.21. $4.80

5.

a. TA = $6,000,000,000; T = 35%; EBIT/TA = 10%; ROA = 2.5%; TIE = ?

EBIT = 0.10 $6,000,000,000 EBIT = $600,000,000. NI = 0.025 $6,000,000,000 NI = $150,000,000.

ANALYSIS OF FINANCIAL STATEMENTS 3 - 17

Now use the income statement format to determine interest so you can calculate the firms TIE ratio. INT = EBIT EBT EBIT $600,000,000 See above. = $600,000,000 $230,769,231 INT 369,230,769 EBT $230,769,231 EBT = $150,000,000/0.65 Taxes (35%) 80,769,231 NI $150,000,000 See above. TIE = EBIT/INT = $600,000,000/$369,230,769 = 1.625.

6.

c. Current ratio =

Current assets $1,070 = = 1.44. Current liabilitie s $745

Sales $2,400 = = 3.84. Inventory $625

7.

a. Inventory turnover =

Fixed assets turnover =

Sales $2,400 = = 2.00. Net fixed assets $1,200 Sales $2,400 = = 1.06. Total assets $2,270

Total assets turnover =

DSO =

Accounts receivable $245 = = 37.26 days. Sales/ 365 $2,400 / 365

8.

d. Debt ratio = Total debt/Total assets = $1,165/$2,270 = 0.51 = 51%. TIE ratio = EBIT/Interest = $175/$35 = 5.00.

9.

b. Profit margin =

Net income $84 = = 0.0350 = 3.50%. Sales $2,400

ROA =

Net income $84 = = 0.0370 = 3.70%. Total assets $2,270

ANALYSIS OF FINANCIAL STATEMENTS 3 - 18

ROE

Net income $84 0.0760 7.60%. Common equity $1,105

BEP

EBIT $175 0.0771 7.71%. Total assets $2,270 Net income $84,000 = = $8.40. Number of shares outstanding 10,000

10.

e. EPS =

P/E ratio =

$40.00 Price = = 4.76. $8.40 EPS

$84,000 $80,000 Net income Depreciation = = $16.40. Number of shares outstanding 10,000

Cash flow/share =

Price/cash flow =

$40.00 = 2.44. $16.40

Market price $40(10,000) = = 0.36. Book value $1,105,000

Market/Book value =

11.

d. ROE = Profit margin Total assets turnover Equity multiplier $84 $2,400 $2,270 = 0.035 1.057 2.054 = $2,400 $2,270 $1,105 = 0.0760 = 7.60%.
Accounts receivable Sales/ 365 AR 42 days = $2,000,000 / 365 AR = $230,137.

12.

a.

DSO =

13.

b.

DSO 73 days 73(Sales/365) Sales

= Accounts receivable/(Sales/365) = $500,000/(Sales/365) = $500,000 = $2,500,000.

ANALYSIS OF FINANCIAL STATEMENTS 3 - 19

14.

b. Net income = $2,000,000(0.06) = $120,000. Earnings before taxes = $120,000/(1 0.4) = $200,000. EBIT = $200,000 + $20,000 = $220,000. TIE = EBIT/Interest = $220,000/$20,000 = 11.

15.

c. Net income = $2,000,000(0.03) = $60,000. Earnings before taxes = $60,000/(1 0.4) = $100,000. EBIT = $100,000 + $40,000 = $140,000. TIE = EBIT/Interest = $140,000/$40,000 = 3.5.