Chapter Eighteen

ANALYZING
FINANCIAL STATEMENTS

LEARNING OBJECTIVES
After reading this chapter, you should be able to
Explain why financial analysts use ratios to evaluate companies.
Explain liquidity and show how ratios can measure a companys liquidity.
Explain profitability and show how ratios can measure a companys profitability.
Explain solvency and show how ratios can measure a companys solvency.
Describe leverage and show how it changes returns to stockholders.
Explain some limitations of ratio analysis.

The financial performance of a company is of major interest to its employ-

ees and shareholders, among others. A companys goals are often stated
in terms of financial results. For example:
Minnesota Mining & Manufacturing (3M) has stated its financial
goals as follows: We strive to maximize shareholder value through
solid, profitable growth and effective use of capital. Specific financial
goals are to achieve (1) at least 30 percent of sales from products in-
troduced during the past four years; (2) growth in earnings per share
of more than 10 percent a year, on average; (3) growth in economic
profit exceeding earnings per share growth, and return on invested
capital among the highest of industrial companies.
Walt Disney Company has stated: The companys primary finan-
cial objective remains 20% compound annual earnings per share
growth over future five-year periods and, secondarily, steady im-
provement in return on equity.
Boise Cascade has stated: We are moving rapidly to achieve
fully competitive positions in all of our businesses and products and
are focused on achieving our financial goals: To be profitable
throughout the business cycle and to be EVA-positive over the
cycle.

Sources: 3M 1997 annual report.

Walt Disney Company 1997 Factbook.
Boise Cascade 1997 annual report.

794
 Chapter Eighteen Analyzing Financial Statements 795

Throughout this book we have stressed the importance of expectations and the
ways that accounting and other information help managers form reasonable ex-
CHAPTER
pectations. We have also used ratios among financial statement elements. Chapter
2 2 showed that managers often express target profits as a ratio of income to sales
CHAPTER
(return on sales). In Chapter 11 you saw that managers commonly use the ratio of
11 income to total assets (or some other measure of return on investment) to measure
CHAPTER divisional performance. Chapter 7 illustrated the cash squeeze that can accom-
7 pany buildups of inventories and receivables, as well as how managers use ratios
when developing long-term plans. This chapter addresses the analysis of finan-
cial statements, including the calculation, interpretation, and evaluation of finan-
cial ratios.
Many people and organizations outside a company, such as suppliers and in-
vestors in debt or equity securities, are interested in the companys activities.
Banks that provide short-term loans, insurance companies that buy long-term
bonds, brokerage firms that give (or sell) investment advice to their customers,
mutual funds that buy stocks or bondsall of these, and many other institutions,
employ financial analysts to help make decisions about individual companies.
Individual investors also perform financial analyses. Our approach to analyzing
financial statements is that of a financial analyst, who makes recommendations to
investors after studying financial statements and other sources of information
about a business. Because an analysts recommendations can affect a companys
ability to obtain credit, sell stock, and secure new contracts, internal managers
must also be aware of what concerns financial analysts.

EXPECTATIONS AND PERFORMANCE

Like a companys managers, financial analysts base their decisions on expecta-

tions about the future. Just as managers focus on forecasts, financial analysts con-
centrate on what the future holds. Analysts want to know what to expect from a
companywhether it will be able to pay its employees and suppliers, repay its
loans, pay dividends on its stock, and expand into new areas. As with company
managers, financial analysts also are concerned with the past only insofar as they
can use the past as a reliable guide to the future. For example, an impressive his-
tory of growth in net income, sales, financial stability, and capable management
is overshadowed if the companys major product is determined to be harmful in
some way (e.g., tobacco, leaded gasoline), or becomes illegal (e.g., asbestos, the in-
secticide DDT) or obsolete (e.g., early types of computers and calculators).
Nevertheless, analysts assume that what has held true in the past is likely to con-
tinue unless they have information that indicates otherwise, much as managers
use a cost prediction formula developed on the basis of past experience. Hence,
both analysts and a companys managers must be continually alert for signs that
the future will differ from the past. In addition to focusing on the future, man-
agers and financial analysts use many of the same analytical approaches.

METHODS OF ANALYSIS

Financial analysis consists of a number of interrelated activities. Among the most

important are considerations of ratios and trends and the comparison of ratios
796 Part Five Special Topics

and trends against some norms. (A norm is a standard for comparison, which
could be an average value for a particular industry or for all companies in the
economy.) Trends are of interest as clues to the future.
Ratios can take three different forms. Some ratios are comparisons of an in-
come statement element with another income statement element. Other ratios are
comparisons of balance sheet elements with other balance sheet elements. Still
others compare an income statement element such as sales or cost of goods sold,
with a balance sheet element such as accounts receivable or total assets. In this last
set of ratios we could use either average assets or assets at year end. Analysts use
both versions, depending on circumstances and preferences. We shall illustrate
this point a few times as we proceed through the ratios. You should keep in mind
that no one version is right and another wrong. Analysts simply have differ-
ing views.

AREAS OF ANALYSIS
Different types of investors are interested in different aspects of a company. Short-
term creditors, such as suppliers and banks considering loans of relatively short
duration (90 days or six months), are concerned primarily with a companys
short-term prospects. They want to know whether a company will be able to pay
its obligations in the near future. Banks, insurance companies, pension funds, and
other investors considering relatively long-term commitments (e.g., ten-year
loans) cannot ignore short-term prospects, but are more concerned with the long-
term outlook. Even if such investors are satisfied that a company has no short-
term problems, they want to be reasonably sure that it has good prospects for
long-term financial stability and can be expected to repay its longer-term loans
with interest.
Stockholders, current and potential, are also interested in both the short-term
and long-term prospects of the company. But their interest goes beyond the com-
panys ability to repay loans and make interest payments. Their concern is with
profitabilitythe ability to earn satisfactory profits and pay dividendsand the
likelihood that the market price of the stock will increase.
We have divided the discussion of these aspects of a companys prospects into
three major areas: liquidity, solvency, and profitability. For the most part we work
with ratios. Apart from expressing relationships between two factors, ratios are
useful because they facilitate comparisons among companies of different sizes.

ILLUSTRATION
We shall use the comparative financial statements and the additional financial in-
formation about Burke Company shown in Exhibit 18-1.
The analysis has actually begun in the exhibit because it shows the percentages
of sales for each item on the income statement and the percentage of total assets
or total equities for each balance sheet item. These percentage statements, or
common-size statements, can help an analyst to spot trends.
Two of the more important percentages on the income statement are the gross
profit ratio, which is gross profit divided by sales, and return on sales (ROS),
which is net income divided by sales. These ratios for Burke in 20X2 are 38.5 and
7.9 percent, respectively. The gross profit ratio improved in 20X2 over 20X1, but
ROS declined.
 Chapter Eighteen Analyzing Financial Statements 797

Exhibit 18-1 Burke Company, Balance Sheets as of December 31

20X2 20X1
Dollars Percent Dollars Percent
Current assets:
Cash $ 80,000 5.2% $ 50,000 3.6%
Accounts receivable, net 180,000 11.6 120,000 8.7
Inventory 190,000 12.2 230,000 16.7
Total current assets $ 450,000 29.0 $ 400,000 29.0
Plant and equipmentcost $1,350,000 87.1 $1,150,000 83.3
Accumulated depreciation (340,000) (21.9) (250,000) (18.1)
Net plant and equipment $1,010,000 65.2 $ 900,000 65.2
Other assets $ 90,000 5.8 $ 80,000 5.8
Total assets $1,550,000 100.0% $1,380,000 100.0%

Current liabilities:
Accounts payable $ 110,000 7.1% $ 105,000 7.6%
Accrued expenses 40,000 2.6 15,000 1.1
Total current liabilities $ 150,000 9.7 $ 120,000 8.7
Long-term debt 600,000 38.7 490,000 35.5
Total liabilities $ 750,000 48.4 $ 610,000 44.2
Common stock, 22,000
shares $ 220,000 14.2 $ 220,000 15.9
Paid-in capital 350,000 22.6 350,000 25.4
Retained earnings 230,000 14.8 200,000 14.5
Total stockholders equity $ 800,000 51.6 $ 770,000 55.8
Total equities $1,550,000 100.0% $1,380,000 100.0%

Burke Company, Income Statements for the Years Ended December 31

20X2 20X1
Dollars Percent Dollars Percent
Sales $1,300,000 100.0% $1,080,000 100.0%
Cost of goods sold 800,000 61.5 670,000 62.0
Gross profit $ 500,000 38.5 $ 410,000 38.0
Operating expensesa 280,000 21.6 210,000 19.4
Income before interest
and taxes $ 220,000 16.9 $ 200,000 18.6
Interest expense 48,000 3.7 42,000 3.9
Income before taxes $ 172,000 13.2 $ 158,000 14.7
Income taxes at 40% rate 68,800 5.3 63,200 5.9
Net income $ 103,200 7.9% $ 94,800 8.8%

a Including depreciation of $90,000 in 20X2 and $75,000 in 20X1

798 Part Five Special Topics

Both financial analysts and internal managers are interested in ROS and the
gross profit ratio because these ratios indicate how valuable a dollar of sales is to
the company. (These ratios are not the same as the contribution margin ratio, but
they do give a rough idea of the profit/sales relationship.) A relatively low ROS,
combined with a gross profit ratio that is normal for the industry, could indicate
that operating expenses are higher than those of other companies. Similarly, a de-
cline in ROS or the gross profit ratio could suggest weakening prices, which could
be very serious. Stocks of many manufacturers of computer chips fall sharply be-
cause of concerns over softening prices, reflected in falling margins. 3Com stated
that its margins declined in late 1997 due to reducing selling prices by as much as
40 percent in order to remain competitive. As we mention several times in this
chapter, ratios provide clues or indicators, but they do not tell you whether a com-
panys managers are acting wisely or unwisely.
Balance sheet ratios show whether the proportions of particular assets or lia-
bilities are increasing or decreasing, and whether they are within reasonable
bounds. We explore balance sheet ratios in more detail later in the chapter.

LIQUIDITY

Liquidity is a companys ability to meet obligations due in the near future. The
more liquid the company, the more likely it will be able to pay its employees, sup-
pliers, and holders of its short-term notes payable. A company with excellent
long-term prospects could fail to realize them because it was forced into bank-
ruptcy when it could not pay its debts in the near term. Hence, while liquidity is
most important to short-term creditors, it also interests long-term creditors and
stockholders.

WORKING CAPITAL AND THE CURRENT RATIO

Working capital, the difference between current assets and current liabilities, is a
very rough measure of liquidity. Burke had the following amounts of working
capital at the end of 20X1 and 20X2.

20X2 20X1
Current assets $450,000 $400,000
Current liabilities 150,000 120,000
Working capital $300,000 $280,000

Working capital is positive and has increased. But this does not necessarily mean
that Burke has adequate liquidity or became more liquid. Most analysts consider
changes in working capital as only a very rough indication of changes in liquid-
ity and supplement their analysis with several other calculations. Working capi-
tal is stated in absolute dollar terms and hence is greatly influenced by the size of
the company.
The current ratio is a measure of relative liquidity that takes into account dif-
ferences in absolute size. It is used to compare companies with different total cur-
rent assets and liabilities as well as to compare the same companys liquidity from
year to year.
 Chapter Eighteen Analyzing Financial Statements 799

current assets
Current ratio =
current liabilities

Burke has current ratios of 3.33 to 1 in 20X1 ($400,000/$120,000) and 3 to 1 in 20X2

($450,000/$150,000). On the basis of the current ratio, we would say that the com-
pany seemed to be less liquid at the end of 20X2. With good reason we said
seemed to be less liquid. One major problem that arises with any ratio, but es-
pecially the current ratio, is that of composition. The composition problem arises
when one uses a total, such as total current assets (or current liabilities), that
might mask information about the individual components. How soon will the
current assets be converted into cash so that they can be used to pay current lia-
bilities? How soon are the current liabilities due for payment? You already know
that current assets normally are listed in order of liquidity from cash, the most liq-
uid, to prepaid expenses. The analyst obtains a general idea of the magnitude of
the composition problem by reviewing the common-size balance sheet to see how
much of current assets consists of relatively liquid items.

QUICK RATIO (ACID-TEST RATIO)

The quick ratio, or acid-test ratio, is cash plus marketable securities plus accounts
receivable divided by current liabilities. It is similar to the current ratio, but in-
cludes only those assets that are cash or near cash (called quick assets). Hence,
the ratio gives a stricter indication of short-term debt-paying ability than does the
current ratio.

cash + marketable securities + accounts receivable

Quick ratio =
current liabilities

Burke had no marketable securities at the end of either year, so its quick ratios are
as follows:

$50,000 + $120,000
20X1 = 1.42
$120,000
$80,000 + $180,000
20X2 = 1.73
$150,000

Burke seems to have increased its liquidity because its quick ratio increased.
We could say that the company was better able to meet current liabilities at the
end of 20X2; but we would still like to know how soon its current liabilities have
to be paid and how rapidly it can expect to turn its receivables and inventory into
cash. The next section presents ratios that measure the liquidity of current assets.

WORKING CAPITAL ACTIVITY RATIOS

Two commonly used ratios provide information about the time within which a
company should realize cash from its receivables and inventories. And, although
we cannot tell the time within which the company must pay its various current li-
abilities simply by examining the financial statements, one commonly used ratio
offers some insight into the companys bill-paying practices.
800 Part Five Special Topics

Accounts Receivable Turnover

Accounts receivable turnover measures how rapidly a company collects its re-
ceivables; in general, the higher the turnover the better.

sales
Accounts receivable turnover =
accounts receivable

Average receivables is defined as the beginning accounts receivable balance plus

the ending balance, divided by 2. The year-end balance also may be used. The
simple averaging procedure is satisfactory so long as there are no extremely high
or low points during the year (including the end of the year). If a companys re-
ceivables fluctuate widely, using a monthly average for receivables is better.
Again, many analysts simply use the year-end value.
Some analysts prefer to use credit sales for the calculation, instead of total
sales, but outsiders typically cannot determine how much of total sales are on
credit or for cash. Internal managers can determine credit sales and thus can com-
pute the turnover of credit sales, as well as of total sales.
Because we do not have the beginning balance for 20X1, we can only calculate
the turnover of average receivables for 20X2 for Burke Company. (We can compute
20X1 turnover using the end of year value.)

$1,300,000 $1,300,000
= = 8.67 times
($120,000 + $180,000)/2 $150,000

The 20X1 turnover using the ending balance is

$1,080,000/$120,000 = 9 times

Some analysts make a related calculation called number of days sales in accounts
receivable. This figure indicates the average age of ending accounts receivable.

ending accounts receivable

Days sales in accounts receivable =
average daily sales

Average daily sales is simply sales for the year divided by 365. For Burke
Company, we have average daily sales of about $2,959 ($1,080,000/365) for 20X1
and about $3,562 ($1,300,000/365) for 20X2. Hence, days sales in accounts re-
ceivable are

$120,000
20X1 = 41 days
$2,959
$180,000
20X2 = 51 days
$3,563

On average, then, Burkes accounts receivable were 41 days old at the end of 20X1
and 51 days old at the end of 20X2. The collection period has lengthened consid-
erably in one year, but the period must be interpreted in light of the credit terms
offered to customers. The faster customers pay, the better, but there are always
trade-offs. If a company loses sales because of tight credit policies, the advantage
of faster collection might be more than offset by the loss of profits from lower total
 Chapter Eighteen Analyzing Financial Statements 801

sales. The increase in the average collection period might well be the result of a
management decision to offer more liberal terms to stimulate sales.

Inventory Turnover
The type of analysis discussed in connection with receivables also applies to the
companys inventory. Inventory turnover is calculated as follows:

cost of goods sold

Inventory turnover =
inventory

Again, most analysts use an average value, the sum of the beginning and ending
balances divided by 2, unless the company has much higher and lower invento-
ries for significant portions of the year because of seasonal business. It is then bet-
ter to use monthly figures to determine the average. And, again, many analysts
simply use the year-end value for inventory.
Burkes inventory turnover for 20X2 is about 3.8 times, calculated as follows:

$800,000 $800,000
= = 3.8 times
($230,000 + $190,000)/2 $210,000

Using only the year-end inventory for 20X1, turnover is 2.9 times
($670,000/$230,000).
Inventory turnover indicates the efficiency with which a company uses its in-
ventory. High inventory turnover is critical for many businesses, especially those
that sell at a relatively low markup (ratio of gross profit to sales) and depend on
high sales volumes to earn satisfactory profits. For example, discount stores and
food stores rely on quick turnover for profitability. Companies with very high
markups, such as jewelry stores, do not need such rapid turnovers to be prof-
CHAPTER
itable.
1 As discussed in Chapters 1, 6, and 9, maintaining inventory can be very ex-
CHAPTER pensive. Some costsinsurance, personal property taxes, interest on the funds
6 tied up in inventory, and obsolescencecan be very high. Therefore, managers
CHAPTER prefer to keep inventory as low as possible. The problem is that if inventory is too
9 low, particularly in retail stores, sales might be lost because customers cannot find
what they want.
Analysts sometimes calculate the number of days sales in inventory, which is
a measure of the supply that the company maintains.

ending inventory
Days sales in inventory =
average daily cost of goods sold

Average daily cost of goods sold is simply cost of goods sold for the year divided
by 365. For Burke, this is $1,836 ($670,000/365) for 20X1 and $2,192
($800,000/365) for 20X2. Days sales in inventory are as follows:

$230,000
20X1 = 125 days
$1,836
$190,000
20X2 = 87 days
$2,192

The decline in days sales in Burkes inventory could indicate a deliberate change
in inventory policy, or perhaps just a temporary reduction of inventory because
802 Part Five Special Topics

of heavier than expected sales near the end of the year. The accompanying Insight
illustrates how Dell Computer Corporation manages working capital to achieve a
strategic advantage.
As you may remember from your study of financial accounting, generally ac-
cepted accounting principles (GAAP) allow several formats for the income state-
ment. Some formats do not show cost of goods sold, so that an outside analyst
cannot compute inventory turnover using the approach just presented. In such
cases, the analyst will use sales as a substitute for cost of goods sold, even though
sales and inventory are not measured in the same way. (Sales is measured in sell-
ing prices, while inventory is measured in cost prices.) The inventory turnover so
derived is overstateda unit costing $1 and sold for $2 will reflect two inventory
turnovers when only one unit has been sold. If analysts recognize the overstate-
ment in the calculation, they will not be misled by the results.

PROFITABILITY

Profitability can be measured in absolute dollar terms, such as net income, or by

ratios. The most commonly used measures of profitability fall under the general

IN SIGHT

Working Capital Ratios at Dell Computer

Dell Computer Corporations business strategy is to sell computers to corpora-
tions and consumers through a direct sales approach. This allows Dell to carry
little or no finished goods inventory and to use the latest components. In the
computer industry, using the latest components also provides the highest
profit margins. It also protects the company against price changes in compo-
nents.
The company focuses on the cash conversion cycle, which consists of in-
ventory, payables, receivables, and cash flow from operations. A recent annual
report presented the following ratios:

1998 1997 1996

Days of Sales in Accounts Receivable 36 37 42
Days of Supply in Inventory 7 13 31
Days in Accounts Payable 51 54 33

In a business where inventory prices drop by 1 percent a week, inventory is risk.

While Dell had 13 days of inventory in 1997, a typical competitor that did not
sell directly had 30, with another 40 in the distribution channel. Thats a dif-
ference of 58 days, Mr. Dell said. In 58 days, the cost of materials will decline
about 6 percent.

Sources: Dell Computer Corporation 1998 annual report.

Andy Serwer, Michael Dell Rocks, Fortune, May 11, 1998, 5870.
Lawrence Fisher, Inside Dell Computer Corporation: Managing Working Capital, Strategy and Business,
First Quarter, 1998, 6875.
 Chapter Eighteen Analyzing Financial Statements 803

CHAPTER
11 heading of return on investment (ROI). As described in Chapter 11, ROI is actu-
ally a family of ratios having the general form
income
Return on investment =
investment
External investors, especially stockholders and potential stockholders, are inter-
ested in the return that they can expect from their investments. A companys man-
agers want to earn satisfactory returns on the investments that they control. As a
practical matter, then, different analysts and managers will define both income and
investment differently when trying to measure the same basic relationships. In this
section, we present some of the most often used alternative ways of looking at this
basic relationship of accomplishment (return, income) to effort (investment).

RETURN ON ASSETS (ROA)

ROA measures operating efficiencyhow well managers have used the assets
under their control to generate income. The following ratio is one way to make
the calculation.
net income + interest + income taxes
Return on assets =
total assets
The familiar alternatives, averages or year-end values, apply here as well. For
Burke, ROA was about 15 percent for 20X2, calculated as follows:
$103,200 + $48,000 + $68,800 $220,000
= = 15.0%
($1,380,000 + $1,550,000)/2 $1,465,000
Adding interest and income taxes back to net income is equivalent to using in-
come before interest and income taxes. Remember that we are concerned with op-
erations: Interest and, to some extent, income taxes depend on how the company
finances its assetshow much debt it uses. Moreover, income taxes are affected
by many matters not related to operations, which is another reason for adding
them back. (Some of these nonoperating factors are the companys investments in
securities and its use of tax benefits such as percentage depletion.) Some analysts
add back only interest; others add back only the after-tax effect of interest. There
are arguments to support several measures of the numerator in the ROA calcula-
tion. Choosing one alternative over another is a matter of both personal prefer-
ence and of the particular objective.
Some analysts use end-of-year assets in the denominator, some use beginning-
of-year amounts, and still others use total assets minus current liabilities.
(Analysts in the latter group argue that current liabilities are operating sources,
rather than financing sources.) In this chapter, we use average total assets, or total
year-end assets, with no consideration of current liabilities, but we caution you
that this is a matter of choice and preference.
Both internal and external analysts can obtain the information for this ratio di-
rectly from publicly available financial statements, and can make direct compar-
isons with companies in the same industry.

RETURN ON COMMON EQUITY (ROE)

ROA is a measure of operating efficiency. Common stockholders are also con-
cerned with the return on their investment, which is affected not only by opera-
804 Part Five Special Topics

tions but also by the amount of debt and preferred stock in the companys capital
structure.
ROE is computed as follows.

net income dividends on preferred stock

Return on common equity =
common stockholders equity

If there is preferred stock, preferred dividends must be subtracted from net in-
come in the numerator, and the amount of total stockholders equity attributable
to preferred stock is subtracted in the denominator to obtain common stockhold-
ers equity.
Burke Company has no preferred stock, but it does have debt. ROE for Burke
in 20X2 is a bit over 13 percent.

$103,200 $103,200
= = 13.1%
($770,000 + $800,000)/2 $785,000

Notice that Burkes ROE is less than its ROA. If a company finances its assets
solely with common stock, such a relationship will hold between ROE and ROA
because ROE is computed using after-tax income. But debt holders do not partic-
ipate in the earnings of the company; they receive a stipulated, constant amount
of interest. Hence, the company can increase its ROE if it uses debt, provided that
ROA is greater than the interest rate it must pay to debt holders. This method of
using debt (or preferred stock) to increase ROE is called leverage or trading on
the equity (sometimes financial leverage). Leverage increases both risk and the
potential for greater return.

THE EFFECTS OF LEVERAGE

Suppose that a company with a 40 percent tax rate requires total assets of
$1,000,000 to earn $180,000 per year before interest and income taxes, for an ROA
of 18 percent. Three possible financing alternatives are (1) all common stock, (2)
$400,000 common stock and $600,000 in 7 percent bonds (interest expense of
$42,000), and (3) $400,000 in common stock and $600,000 in 8 percent preferred
stock (dividends of $48,000). The following schedule shows the differing effects
of the three alternatives on ROE.

(1) (2) (3)

Preferred
Debt and Stock and
All Common Common Common
Stock Stock Stock
Income before interest and taxes $ 180,000 $180,000 $180,000
Interest expense at 7% 0 42,000 0
Income before taxes $ 180,000 $138,000 $180,000
Income taxes at 40% 72,000 55,200 72,000
Net income $ 108,000 $ 82,800 $108,000
Less preferred stock dividends 0 0 48,000
Earnings available for common stock $ 108,000 $ 82,800 $ 60,000
Divided by common equity invested 1,000,000 400,000 400,000
Equals return on common equity 10.8% 20.7% 15.0%
 Chapter Eighteen Analyzing Financial Statements 805

Note that dividends on preferred stock must be subtracted from net income to
reach earnings available for common stockholders (because the claim of preferred
stockholders on company earnings comes before the claim of common stock-
holders). Note also that, although the plans that include debt or preferred stock
both result in lower earnings available for common equity, both produce a higher
ROE than the company would achieve if it used all common equity. That is, these
two plans provide the benefits of leverage.
However, leverage works both ways. It is good for the common stockholder
when earnings are high and bad when they are low. If in one year the company
earns only $60,000 before interest and taxes, it has the following results.

(1) (2) (3)

All $600,000 $600,000
Common Debt Preferred
Income before interest and taxes $ 60,000 $ 60,000 $ 60,000
Interest expense at 7% 0 42,000 0
Income before taxes $ 60,000 $ 18,000 $ 60,000
Income taxes at 40% 24,000 7,200 24,000
Net income $ 36,000 $ 10,800 $ 36,000
Less preferred stock dividends 0 0 42,000
Earnings available for common stock $ 36,000 $ 10,800 $ (6,000)
Divided by common equity invested 1,000,000 400,000 400,000
Equals return on common equity 3.6% 2.7% negative

As you can see, ROE is highest if all common equity is used, but the return is very
low. Companies having relatively stable revenues and expenses, such as public
utilities, can use considerable leverage. Leverage is very risky for companies in
cyclical industries such as automobile and aircraft manufacturing, and construc-
tion, where income fluctuates greatly from year to year. A couple of bad years in
a row could bring a heavily leveraged company into bankruptcy. During the
1980s, leverage was so important in the acquisition of entire companies that the
term leveraged buyout (LBO) became a standard part of financial discussions.
Often such acquisitions were financed with high-yield bonds, called junk bonds
because of their high risk.

EARNINGS PER SHARE (EPS)

Investors in common stock are less concerned with a companys total income than
with their share of that income as expressed by the companys earnings per share
(EPS). EPS is the most widely cited statistic in the financial press, the business sec-
tion of newspapers, and recommendations by brokerage firms and other invest-
ment advisers. In simple cases, EPS is calculated as follows:

net income dividends on preferred stock

Earnings per share (EPS) =
weighted average common shares outstanding

The weighted average of common shares outstanding is the best measure of the
shares outstanding throughout the period when the income is earned. If Burke
has 22,000 shares outstanding all through 20X1 and 20X2, as well as at the ends of
those years, its EPS figures are
806 Part Five Special Topics

$94,800 $0 $94,800
20X1 = = $4.31
22,000 22,000
$103,200 $0 $103,200
20X2 = = $4.69
22,000 22,000

EPS in 20X2 was $0.38 higher than in 20X1. This is an 8.8 percent growth rate,
which we calculate as follows:

EPS current year EPS prior year

Growth rate of EPS =
EPS prior year

The greater the growth that investors expect, the more they are willing to pay for
the common stock. Of course, an increase in EPS from one year to the next does
not always mean that the company is growing; it might simply reflect a rebound
from a particularly poor year. EPS could also increase (or decrease) because of an
unusual event that is unlikely to recur frequently. (Financial accounting refers to
such events as extraordinary items.) Many analysts compare EPS numbers with-
out the effects of extraordinary items and other one-time events such as the dis-
continuance of a major segment of the business or a change in accounting
principle used to prepare financial statements, such as a change from FIFO to
LIFO. GAAP accommodates that practice by requiring the reporting of an EPS
number before extraordinary items, gains or losses on discontinued operations,
and changes in accounting principle. In any case, growth rates should be calcu-
lated over a number of years, rather than for a single year as we have done here.
The accompanying Insight explores the growth rates of selected companies.
Some companies issue convertible securities, bonds and preferred stock that
can be converted into common stock at the option of the owner. Conversion poses
the problem of potential dilution (decreases) in EPS, because earnings have to be
spread over a greater number of shares.1 Calculating EPS when dilution is possi-
ble can be extremely complex. We shall show a single, relatively simple, illustra-
tion. Assume that a company has net income of $200,000, 80,000 common shares
outstanding, and an issue of convertible preferred stock. The preferred stock pays
dividends of $20,000 and is convertible into 30,000 common shares. Using the
basic formula, EPS is $2.25.

$200,000 $20,000 $180,000

= = $2.25
80,000 80,000

The company will show the $2.25 as basic earnings per share on the income state-
ment. Then the income statement will report another EPS number, called diluted
earnings per share. Diluted EPS is a pro forma calculation that shows what EPS
would have been if convertible securities had actually been converted into com-
mon stock at the beginning of the year. Had the conversion occurred, there would
have been no preferred dividends, but an additional 30,000 common shares
would have been outstanding for the entire year. We calculate diluted EPS by
adding back the preferred dividends on the convertible stock to the $180,000 earn-
ings available for common stock and adding 30,000 shares to the denominator.

1 The computation of EPS is governed by Statement of Financial Accounting Standards No. 128 (Stamford, CT:
Financial Accounting Standards Board, 1997).
 Chapter Eighteen Analyzing Financial Statements 807

IN SIGHT

High-Growth Companies
Many investors, called growth investors, seek out stocks with rapidly increas-
ing profits, and such stocks can be very volatile. Fortune magazine publishes an
annual listing of Americas fastest growing companies. Some of these compa-
nies will be stellar investments (Dell Computers stock price grew from a stock-
adjusted 1990 price of $0.23 to a 1998 high of $128.63, a 55,826 percent gain).
Other companies on this list will be losers. The challenge of investing in growth
stocks is to be able to tell which stock will be in which group.
A sampling of the 1998 list is as follows:

Average Annual
EPS growth revenue Estimated
(3-year average) growth P/E
Noble Drilling 394% 36% 10
Vitesse Semiconductor 227% 55% 49
Rainforest Caf 113% 175% 13
Dell Computer 90% 53% 57

Source: Fortune, September 28, 1998.

$180,000 + $20,000 $200,000

= = $1.82 diluted EPS
80,000 + 30,000 110,000

PRICE-EARNINGS RATIO (PE)

The PE ratio is the ratio of the market price of a share of common stock to its EPS.
The ratio indicates the amount investors are paying to buy a dollar of earnings.
PE ratios of high-growth potential companies are often very high; those of low-
growth potential or declining companies tend to be low. Assume that Burkes
common stock sold at $60 per share at the end of 20X1 and $70 at the end of 20X2.
The PE ratios are

market price per share

Price-earnings ratio =
earnings per share
$60.00
20X1 = = 13.9
$4.31
$70.00
20X2 = = 14.9
$4.69

The increase in the PE ratio from 20X1 to 20X2 could have happened because EPS
had been growing rather slowly until 20X2 and investors believed the growth rate
would increase in the future. Such a situation justifies a higher PE ratio. Or per-
 808 Part Five Special Topics

haps PE ratios throughout the economy increased because of good economic

news and expectations of good business conditions.

DIVIDEND YIELD AND PAYOUT RATIO

We have been viewing earnings available for common stockholders as the major
return accruing to owners of common stock. But investors do not get EPS. They
receive dividends and, they hope, increases in the market value of their shares.
The dividend yield is a measure of the current cash income that an investor can
obtain per dollar of investment.

dividend per share

Dividend yield =
market price per share

Burke declared and paid dividends of $63,000 in 20X1 and $73,200 in 20X2 on
22,000 shares, giving dividends per share of $2.86 and $3.33 for 20X1 and 20X2,
respectively. Given per-share market prices of $60 and $70 at the ends of 20X1 and
20X2, dividend yields are

$2.86
20X1 = 4.77%
$60.00
$3.33
20X2 = 4.76%
$70.00

The payout ratio is the ratio of dividends per share to EPS. For Burke, the payout
ratio in 20X2 is 71 percent ($3.33/$4.69) and in 20X1 was 66 percent ($2.86/$4.31).
In general, companies with high growth rates have relatively low dividend yields
and payout ratios. Such companies are investing the cash they could use for div-
idends. Investors who favor high-growth companies are not looking for divi-
dends so much as for increases in the market price of the common stock. Because
such hoped-for increases might or might not occur, investing in high-growth
companies is generally riskier than investing in companies that pay relatively
high, stable dividends.

ECONOMIC VALUE ADDED (EVA)

CHAPTER
11 Chapter 11 referred to EVA in the context of divisional performance evaluation
and compared it with residual income. The proponents of EVA argue that it is the
best measure of the success of a company as a whole. EVA is computed as

EVA = After-tax operating income (cost of capital investment)

After-tax operating income is income before interest and taxes multiplied by one
minus the tax rate. EVA proponents define investment differently from GAAP.
Some explanations of EVA give investment as total assets less current liabilities,
plus expenditures made for long-term purposes. Expenditures for research and
development and for employee training are common examples. They advocate
amortizing such investments over five years. Suppose Burkes cost of capital is 9
percent and that it has no investments we need to add back. Its EVA for 20X2 is
 Chapter Eighteen Analyzing Financial Statements 809

EVA = $220,000 (1 40%) [9% ($1,550,000 $150,000)]

= $132,000 9% $1,400,000
= $6,000

The $6,000 EVA says that Burke is covering its cost of capital and providing ad-
ditional economic value to its shareholders. The accompanying Insight illustrates
how companies set financial goals using EVA.

SOLVENCY

Solvency refers to long-term safety, the likelihood that the company will be able
to pay its long-term liabilities. Solvency is similar to liquidity but has a much
longer time horizon. Both long-term creditors and stockholders are interested in
solvencylong-term creditors because of a concern about receiving interest pay-
ments and a return of principal, stockholders because they cannot receive divi-
dends and benefit from increased market prices unless the company survives.

DEBT RATIO
One common measure of solvency is the debt ratio, which is calculated as shown
on the following page.

IN SIGHT

Economic Value Added Goals at Champion International

When we announced a new strategic direction for Champion on October 8,
1997, we committed the company to a goal of maximizing total shareholder re-
turn. To do this, we will focus on those businesses that have the greatest op-
portunity for us to earn an economic profit; we will significantly improve our
profitability; and we will exercise strong financial discipline in all our spending.
Improving the way we serve our customers will help us achieve a sustainable
competitive advantage. In the course of implementing this new strategic direc-
tion, we will help to build a different Champion. Our governing objective is
clearto maximize total shareholder return. To accomplish this objective, we
must create economic profit in all of our businesses by earning at a level that is
in excess of our capital charge. Our ambitious goal is to earn an 11 percent re-
turn on capital employed and perform in the top quartile of our industry.
Incentive compensation for key managers has been tied to shareholder return
through a performance share plan. This plan will pay out only if, at any time
within three years from inception, the total return to our shareholders has in-
creased at a rate that is equivalent to approximately 15 percent per annum com-
pounded for three years.

Source: Letter to Shareholders, 1997 annual report.

810 Part Five Special Topics

total liabilities
Debt ratio =
total assets

This ratio measures the proportion of debt in a companys capital structure. It is

also called the debt-to-assets ratio. As with other ratios, variations provide much
the same information. For example, some analysts calculate a debt-to-equity ratio,
dividing total liabilities by stockholders equity; others calculate a ratio of long-
term liabilities to total assets or of long-term liabilities to long-lived assets, such
as property, plant, and equipment. All of these variations have the same basic ob-
jective: to determine the companys degree of debt. The higher the proportion of
debt in the capital structure, the riskier the company. Companies in different in-
dustries can handle different percentages of debt. For example, public utilities
typically have very high percentages of debt because they have stable cash flows,
manufacturers somewhat lower.
The debt ratios for Burke Company for 20X1 and 20X2 are

$610,000
20X1 = = 44.2%
$1,380,000
$750,000
20X2 = = 48.4%
$1,550,000

Notice that if we subtract the debt ratio from 100 percent, we get the proportion
of stockholders equity in the capital structure. This is usually called the equity
ratio. Like the debt ratio, it is a way of measuring solvency, but from a different
standpoint.
Burkes debt ratio increased from 20X1 to 20X2, but we cannot tell whether it
is near a dangerous level without knowing a good deal more. We can obtain some
additional information by calculating the burden that interest expense places on
the company.

TIMES INTEREST EARNED

Times interest earned, or interest coverage, measures the extent to which opera-
tions cover interest expense. The higher the ratio, the more likely the company
will be able to continue meeting the interest payments.

income before interest and taxes

Times interest earned =
interest expense

Burke had interest coverage of 4.8 times in 20X1, but slipped to 4.6 times in 20X2.

$200,000
20X1 = 4.8 times
$42,000
$220,000
20X2 = 4.6 times
$48,000

We use income before interest and taxes because interest is a tax-deductible ex-
pense. Some analysts also add depreciation in the numerator. Reasoning that de-
preciation does not require cash payments, these analysts believe that the
numerator in their ratio approximates the total amount of cash available to pay
interest.
 Chapter Eighteen Analyzing Financial Statements 811

CASH FLOW TO TOTAL DEBT

A classic study of ratios computed for actual companies showed that the single
best ratio for predicting a companys failure was the ratio of cash flow to total
debt.2 In that study, cash flow was defined as net income plus depreciation, amor-
tization, and depletion, and total debt was defined as total liabilities plus pre-
ferred stock.

net income + depreciation + amortization + depletion

Cash flow to total debt =
total liabilities + preferred stock

Burke has no amortization or depletion and no preferred stock. Therefore, the val-
ues of the ratio are

$94,800 + $75,000 $169,800

20X1 = = 27.8%
$610,000 $610,000
$103,200 + $90,000 $193,200
20X2 = = 25.8%
$750,000 $750,000

The research study drawing attention to this ratio was conducted before compa-
nies were required to provide a cash flow statement as part of the financial state-
ment package. Using the operating cash flow taken directly from Burkes cash
flow statement, the ratios are

$177,600
20X1 = 29.1%
$610,000
$203,200
20X2 = 27.1%
$750,000

Though both versions of this solvency ratio show a decline, the decline does not
seem serious. Nevertheless, comparison of the ratio with the industry average
might indicate a potential problem.
Other uses of cash flow ratios have become popular, especially now that GAAP
requires virtually every publicly traded company to publish its cash flow state-
ment. A number of different forms of cash flow ratios can be computed.3 Analysts
use ratios to assess the adequacy of a companys cash flow for financing opera-
tions and its growth. The accompanying Insight describes how cash ratios can
provide information other balance sheet ratios cannot.

RATIOS AND EVALUATION

Calculating ratios for the current year is only the starting point in analyzing a
companys operations and prospects. Comparisons are critical and many factors
besides the magnitudes of the ratios must be considered.

2 See William H. Beaver, Financial Ratios as Predictors of Failure, Empirical Research in Accounting, Selected
Studies, 1966, Journal of Accounting Research, 1967, 71111.
3 For an excellent discussion of cash flow ratios, see John Mills and Jeanne Yamamura, The Power of Cash Flow Ratios,
Journal of Accountancy, October 1998, 5361.
812 Part Five Special Topics

IN SIGHT

Cash Flow Ratios

Boomtown was a Nevada casino company that went public in 1992. By 1996,
Boomtown had four properties in three different states. Total assets increased
over this time period from $56 million in 1992 to $206 million in 1996. The cur-
rent ratio and the quick ratio for the 5-year period would lead an analyst to be-
lieve Boomtown was a strong company financially.
Cash flow ratios pointed out severe problems. Boomtowns growth was
funded almost exclusively through outside funds. In 1997, Boomtown ran out
of cash and was acquired by Hollywood Park, Inc.

Source: John Mills and Jeanne Yamamura, Case Study: Running a Casino Is Not a Game, Journal of
Accountancy, October 1998, 5455.

Analysts should compare ratios with those from prior years, evaluate trends,
and explore related ratios. (Is the company becoming more or less liquid? More or
less profitable? Were changes in sales and ROA consistent with changes in
turnovers of receivables and inventory?) Whenever possible, analysts also compare
a companys ratios with those of similar companies and with those for the indus-
try as a whole. (Are the companys ratios consistent with, and moving in the same
direction as, those for the industry? Are out-of-line ratios or trends explainable?)
Several factors make both inter-company and industry comparisons difficult.
Comparisons become more difficult as more and more companies diversify their
operations. Highly diversified companies might operate in fifteen or more differ-
ent industries. A welcome trend in financial reporting is increased disclosure of
data about the major segments of diversified companies. Such additional disclo-
sure allows analysts to make comparisons that were not possible when only over-
all results were available.
Even comparisons with fairly similar companies must be made with care, be-
cause ratios can differ considerably when companies use different accounting
methods. For example, differences in the accounting methods used to value in-
ventory (e.g., FIFO and LIFO) can influence many ratios. If purchase prices have
generally been rising, a company using LIFO will show a lower inventory, current
ratio, ROS, and EPS, and a higher inventory turnover than a company using
FIFO. The longer the price trend has continued and the longer the company has
used LIFO, the more marked the effects of the difference in inventory method.
Consider too the effects of different depreciation methods on ratios. A business
using the sum-of-the-years-digits method will show lower book values for its
plant assets than one using the straight-line method; the differences will affect all
ratios involving total assets, net income, or both.
Even comparisons among similar companies using similar accounting meth-
ods can be misleading in the sense that one business could show up better than
another in several measures of liquidity, profitability, or solvency and still not be
better managed, more successful, or stronger than the other. For example, a com-
pany might be too liquid. Too much cash is not as bad as too little cash, but hav-
 Chapter Eighteen Analyzing Financial Statements 813

ing excessive cash is unwise, because cash does not earn profits unless it is used
for something. Faster turnover of inventory could be the result of unnecessarily
low selling prices. A shorter collection period on receivables could result from
highly restrictive credit policies. Hence, turnovers must be studied in relation to
ROS and gross profit ratios, and to trends in the industry. In short, no single ratio,
or group of ratios, should be considered in a vacuum.
Another factor to consider in evaluating a company is the extent to which one
or more ratios can be affected by a single transaction. For example, consider the
effects of a large cash payment for a current liability. Such a payment reduces both
cash and current liabilities, and has no effect on total working capital. Yet it can
improve the current ratio. To illustrate, look at the ratios for Burke Company for
20X2 and assume that it paid current liabilities of $30,000 just before the end of
that year. Its current assets before the payment would have been $480,000
($450,000 + $30,000), and its current liabilities would have been $180,000 ($150,000
+ $30,000), giving a current ratio of 2.67 to 1. This ratio is lower than the 3 to 1 we
calculated earlier. Before the payment the acid-test ratio would have been 1.6 to 1
[($80,000 + $180,000 + $30,000)/($150,000 + $30,000)]. This is also lower than the
ratio calculated earlier (1.73 to 1). Taking actions to improve ratios is called win-
dow dressing. This type of window dressing is possible if the current ratio and
acid-test ratio are greater than 1 to 1. If those ratios are less than 1 to 1, paying a
current liability will reduce them, but window dressing is then possible by de-
laying payments of current liabilities.
Any evaluation based on ratios and comparisons of them must recognize the
relative importance of the ratio to the particular industry. The nature of the prod-
uct and of the production process, the degree of competition in the industry, and
many other industry-related factors are relevant in interpreting a particular com-
panys liquidity, profitability, and solvency ratios. For example, consider the util-
ity industry. Because a utility is a monopoly, the government unit granting the
monopoly right also regulates many of the utilitys actions. In most cases, the reg-
ulating authority both ensures and limits the utilitys profitability. Utilities sel-
dom have liquidity problems, because their cash flows are relatively stable,
because selling a service means they need not maintain inventories, and because
their ability to shut off the service minimizes problems in collecting their receiv-
ables. For the same reasons, the investing public tolerates more leverage and a
lower, but more stable, level of profitability in a utility.
All of the preceding considerations point out the need for understanding (1)
the company being analyzed and (2) the industry in which the company operates.
That a companys ratios differ from those in the past, or are in-line or out-of-line
with those of other companies in the industry, is not good or bad in itself. (In the
1980s, Chrysler Corporation improved its liquidity, profitability, and prospects for
solvency, in relation to both its prior performance and to the average for the in-
dustry. Nevertheless, the entire industry performed poorly during that period.)
Finally, financial statements do not tell analysts all they want to know.

SUMMARY

Ratio analysis is used in making investment decisions. Analysts are concerned

with trends in ratios and with whether a companys ratios are in line with those
814 Part Five Special Topics

of other companies in the same industry. Ratios can be classified into three major
types: liquidity, profitability, and solvency.
Which ratios to use and which to emphasize depend on the type of decision to
be made. Short-term creditors look primarily at liquidity. Long-term creditors are
concerned more with solvency than with liquidity and profitability, but the latter
aspects are still important. Current and potential holders of common stock are
most interested in profitability, but liquidity and solvency are still significant.
Ratio analysis must be used with care. Ratios provide information only in the
context of a comparison. Comparisons must be made with other companies and
with norms for the industry. Different accounting methods, such as LIFO and
FIFO, sum-of-the-years-digits depreciation and straight-line depreciation, can
cause similar companies to show quite different ratios.

KEY TERMS

cash flow to total debt (811) liquidity (798)

common-size statements (796) quick assets (799)
composition problem (799) solvency (809)
convertible securities (806) window dressing (813)
dilution (of earnings per share) (806) working capital (798)
leverage (trading on the equity) (804)

KEY FORMULAS

Liquidity Ratios
sales
Accounts receivable turnover =
accounts receivable
current assets
Current ratio =
current liabilities
ending accounts receivable
Days sales in accounts receivable =
average daily sales
ending inventory
Days sales in inventory =
average daily cost of goods sold
cost of goods sold
Inventory turnover =
inventory
cash + marketable securities + accounts receivable
Quick ratio =
current liabilities

Profitability Ratios
dividend per share
Dividend yield =
market price per share
net income dividends on preferred stock
Earnings per share (EPS) =
weighted average common shares outstanding
EVA = After-tax operating profit (cost of capital investment)
 Chapter Eighteen Analyzing Financial Statements 815

gross profit
Gross profit ratio =
sales
dividend per share
Payout ratio =
earnings per share
market price per share
Price-earnings ratio (PE) =
earnings per share
net income + interest + income taxes
Return on assets (ROA) =
total assets
Return on common net income dividends on preferred stock
=
equity (ROE) common stockholders equity
net income
Return on sales (ROS) =
sales

Solvency Ratios
total liabilities
Debt ratio =
total assets
income before interest and taxes
Times interest earnings =
interest expense
net income + depreciation + amortization + depletion
Cash flow to total debt =
total liabilities + preferred stock

REVIEW PROBLEM

Financial statements for Q-Comm Company follow.

Q-Comm Company, Balance Sheets at December 31

20X3 20X2
Assets
Cash $ 180,000 $ 200,000
Accounts receivable, net 850,000 830,000
Inventory 620,000 560,000
Total current assets $ 1,650,000 $ 1,590,000
Plant and equipment 7,540,000 6,650,000
Accumulated depreciation (1,920,000) (1,500,000)
Total assets $ 7,270,000 $ 6,740,000
Equities
Accounts payable $ 220,000 $ 190,000
Accrued expenses 450,000 440,000
Total current liabilities $ 670,000 $ 630,000
Long-term debt 1,000,000 950,000
Total liabilities $ 1,670,000 $ 1,580,000
Common stock, no par value 4,000,000 4,000,000
Retained earnings 1,600,000 1,160,000
Total equities $ 7,270,000 $ 6,740,000
816 Part Five Special Topics

Q-Comm Company, Income Statement for 20X3

Sales $8,650,000
Cost of goods sold 4,825,000
Gross profit $3,825,000
Operating expenses:
Depreciation $ 420,000
Other 2,135,000
Total 2,555,000
Income before interest and taxes $1,270,000
Interest expense 70,000
Income before taxes $1,200,000
Income taxes at 30% 360,000
Net income $ 840,000

Q-Comm Company, Cash Flow Statement for 20X3

Net cash flow from operating activities:
Collections from customers $ 8,630,000
Payments to suppliers (4,855,000)
Payments for operating expenses (2,163,000)
Interest paid (72,000)
Taxes paid (320,000)
Net cash provided by operations $ 1,220,000
Cash flows for investing activitiespurchase
of plant and equipment (890,000)
Cash flows for financing activities:
Payment of dividends $(400,000)
Proceeds from new long-term debt issue 50,000
Net cash for financing activities (350,000)
Change in cash (decrease) $ (20,000)
Cash balance, beginning of year 200,000
Cash balance, end of year $ 180,000

Q-Comm had 200,000 shares of common stock outstanding throughout the year. The
market price of the stock at year end was $65 per share. All sales are on credit.

Required
Compute the following ratios as of the end of 20X3 or for the year ended December
31, 20X3, whichever is appropriate.
1. Current ratio.
2. Quick ratio.
3. Accounts receivable turnover.
4. Days sales in accounts receivable.
5. Inventory turnover.
6. Days sales in inventory.
7. Gross profit ratio.
8. Return on sales (ROS).
9. Return on assets (ROA).
10. Return on equity (ROE).
 Chapter Eighteen Analyzing Financial Statements 817

11. Earnings per share (EPS).

12. Price-earnings ratio (PE).
13. Dividend yield.
14. Payout ratio.
15. EVA, assuming cost of capital is 12%.
16. Debt ratio.
17. Times interest earned.
18. Cash flow to total debt.

ANSWER TO REVIEW PROBLEM

1. Current ratio
$1,650,000
= 2.46 to 1
$670,000
2. Quick ratio
$180,000 + $850,000
= 1.54 to 1
$670,000
3. Accounts receivable turnover
$8,650,000
= 10.3 times
($850,000 + $830,000)/2
4. Days sales in accounts receivable
$850,000
= 36 days
$8,650,000/365
5. Inventory turnover
$4,825,000
= 8.2 times
($620,000 + $560,000)/2
6. Days sales in inventory
$620,000
= 47 days
$4,825,000/365
7. Gross profit ratio
$3,825,000
= 44.2%
$8,650,000
8. ROS
$840,000
= 9.7%
$8,650,000
9. ROA
$840,000 + $70,000 + $360,000
= 18.1%
($7,270,000 + $6,740,000)/2
10. ROE
$840,000
= 15.6%
($5,600,000 + $5,160,000)/2
11. EPS

$840,000
= $4.20
200,000
818 Part Five Special Topics

12. PE ratio
$65.00
= 15.5 times
$4.20
13. Dividend yield
$2
= 3.1%
$65
14. Payout ratio
$2.00
= 47.6%
$4.20
15. EVA
$1,270,000 (1 30%) [12% ($7,270,000 $670,000)] = $97,000
16. Debt ratio
$1,670,000
= 23.0%
$7,270,000
17. Times interest earned
$1,270,000
= 18 times
$70,000
18. Cash flow to total debt
$840,000 + $420,000
= 75.4%
$1,670,000

ASSIGNMENT MATERIAL
INTERNET ACTIVITY

The Association for Investment Management and Research (AIMR) sponsors a certi-
fication for financial analysts known as Chartered Financial Analyst (CFA). Use a Web
search engine such as Yahoo to find the AIMR Web site. Search this site to find out
about the CFA examination. Be prepared to describe and discuss what you discov-
ered.

QUESTIONS FOR DISCUSSION

18-1 Dividend yield Your friend bought stock in Acme Corporation five years ago
for $25 per share. Acme is now paying a $5 dividend per share and the stock sells for
$165. He says that the 20% dividend yield is an excellent return. How did he calcu-
late the dividend yield? Is he correct?

18-2 Ratios and accounting methods LIFO Company uses the last-in first-out
method of inventory determination; FIFO Company uses first-in first-out. They have
virtually identical operations, physical quantities of inventory, sales, and fixed assets.
What differences would you expect to find in the ratios of the companies?
 Chapter Eighteen Analyzing Financial Statements 819

18-3 Ratios and operating decisions Bronson Company and Corman Company
are in the same industry and have virtually identical operations. The only difference
between them is that Bronson rents 60% of its plant and equipment on short-term
leases, while Corman owns all of its fixed assets. Corman has long-term debt of 60%
of the book value of its fixed assets, Bronson has none. The two companies show the
same net income because Bronsons rent and depreciation are the same as Cormans
depreciation and interest. What differences would you expect to find in the ratios of
the two companies?

18-4 Foreign exchange risk Coca-Cola gains about 82% of its operating profit out-
side the United States. It makes most of the product it sells overseas in the host
countries. If the dollar strengthens against foreign currencies (a dollar buys more
units of foreign currency), will that help or hurt the company? Why?

18-5 Liquidity You are the chief loan officer of a medium-size bank. Two compa-
nies have applied for short-term loans, but you can grant only one because of lim-
ited funds. Both companies have the same working capital and the same current
ratio. They are in the same industry and their current ratios are well above the in-
dustry average. What additional information about their current positions would you
seek?

18-6 Seasonality and ratios

1. At December 31, 1997, Hasbro, Inc., the toy company, had $783 million accounts
receivable. Sales for 1997 were $3,189 million. What are days sales in accounts
receivable? Why might Hasbros days sales in receivables seem high at
December 31?
2. Hasbros inventories at December 31, 1997 were $243 million and its cost of sales
for 1997 was $1,359 million. What was its inventory turnover? Do you think the fig-
ure reflects what Hasbro experiences throughout the year?

18-7 Price-earnings ratio Your friend says that his investment strategy is simple.
He buys stocks with very low PE ratios. He reasons that he is getting the most for his
money that way. Do you agree that this is a good strategy?

18-8 Relevance of ratios to industry The 1997 annual report of Bangor Hydro-
Electric Company, a regional electric utility, contained the usual set of financial state-
ments. A condensed balance sheet follows, in thousands of dollars.

December 31
1997 1996
Assets
Utility plant $288,754 $279,801
Current assets 33,443 37,060
Deferred debits and other assets 278,386 239,768
Total assets $600,583 $556,629
Capitalization and Liabilities
Stockholders equity $106,558 $108,321
Preferred stock 13,871 15,404
Long-term debt 221,643 274,221
Current liabilities 105,213 68,155
Deferred credits 153,298 90,528
Total capitalization and liabilities $600,583 $556,629
820 Part Five Special Topics

Required
Discuss the relevance of the three ratio groups to the analysis of a company such as
Bangor Hydro-Electric.

18-9 Ratio variation The Financial Highlights section of an annual report of

Motorola Inc. included the values of the following ratios.
1. Return on average invested capital (stockholders equity) plus long-term and
short-term debt, net of marketable securities.
2. Percent of total debt less marketable securities to total debt less marketable secu-
rities plus equity.
To which of the three general categories of ratios does each of these ratios belong?
How would you explain why the components of these ratios differ from those given
in the chapter?

EXERCISES

18-10 Effects of transactions Indicate the effects of each of the following transac-
tions on the companys (a) current ratio and (b) acid-test ratio. There are three pos-
sible answers: (+) increase, () decrease, and (0) no effect. Before each transaction
takes place, both ratios are greater than 1 to 1.

Effects on
(a) (b)
Current Acid-Test
Transaction Ratio Ratio
Example: Sell merchandise for cash + +
1. Buy inventory for cash. _______ _______
2. Pay an account payable. _______ _______
3. Borrow cash on a short-term loan. _______ _______
4. Purchase plant assets for cash. _______ _______
5. Issue long-term bonds payable. _______ _______
6. Collect an account receivable. _______ _______
7. Record accrued expenses payable. _______ _______
8. Sell a plant asset for cash at a profit. _______ _______
9. Sell a plant asset for cash at a loss. _______ _______
10. Buy marketable securities, for cash, as a
short-term investment. _______ _______

18-11 Relationships Answer the questions for each of the following independent
situations.
1. The current ratio is 2.5 to 1. Current liabilities are $200,000. What are current as-
sets?
2. ROA is 18%. ROE is 10%. There is no preferred stock. Net income is $4 million and
average total assets are $30 million. What is average stockholders equity?
3. The current ratio is 2.5 to 1; the acid-test ratio is 0.9 to 1; cash and receivables are
$270,000. The only current assets are cash, receivables, and inventory. (a) What
are current liabilities? (b) What is inventory?
4. Accounts receivable turnover is 5 times; inventory turnover is 4 times. The com-
pany recently bought inventory. (a) On the average, how long will it be before the
 Chapter Eighteen Analyzing Financial Statements 821

new inventory is sold? (b) On the average, how long after the inventory is sold will
cash be collected?
5. A company had current assets of $600,000. It then paid a current liability of
$90,000. After the payment, the current ratio was 2 to 1. What were current liabil-
ities before the payment was made?
6. Accounts receivable equal 45 days credit sales. The coming year should see sales
of $900,000 spread evenly over the year. What should accounts receivable be at
the end of the year?

18-12 Leverage Balance Company is considering the retirement of $500,000 in

10% bonds. These bonds are the companys only interest-bearing debt. The retire-
ment plan calls for the company to issue 10,000 shares of common stock at a total
price of $500,000 and use the proceeds to buy back the bonds. Stockholders equity
is now $1,000,000, with 40,000 shares of common stock outstanding (no preferred
stock). The company expects to earn $400,000 before interest and taxes in the com-
ing year. The tax rate is 40%.

Required
1. Determine net income, EPS, and ROE for the coming year, assuming that the
bonds are retired before the beginning of the coming year.
2. Determine net income, EPS, and ROE for the coming year, assuming that the
bonds are not retired.
3. Is the proposed retirement wise? Why or why not?

18-13 Return on assets and return on equity Z-Way Corporation had ROS of 5%
and sales of $24 million. Interest expense is $0.3 million; total assets are $16 million;
the debt ratio is 40%. There is no preferred stock. Ignore taxes.

Required
1. Determine income, ROA, and ROE.
2. Suppose the company could increase its ROS to 6% and keep the same level of
sales. What would net income, ROA, and ROE be?
3. Suppose that the company reduced its debt ratio to 20% by retiring debt. New
common stock was issued to finance the retirement, keeping total assets at $16
million. Net income is $1.35 million because of lower interest expense that now
totals $0.15 million. What are ROA and ROE?

18-14 Financing alternatives The founders of Marmex Company are trying to de-
cide how to finance the company. They have three choices:
(a) Issue $8,000,000 in common stock.
(b) Issue $4,800,000 in common stock and $3,200,000 in 10% bonds.
(c) Issue $4,800,000 in common stock and $3,200,000 in 12% preferred stock. Income
before interest and taxes is expected to be $2,000,000. The tax rate is 40%.

Required
1. Compute net income, earnings available for common stock, and ROE for each fi-
nancing choice.
2. Suppose that the tax rate increases to 60%. Redo requirement 1. Can you draw
any conclusions about the effects of tax rates on the relative desirability of the
three choices?

18-15 Turnovers and ratios for computer companies The following amounts have
been collected from the annual reports for selected computer companies for 1996
and 1997.
822 Part Five Special Topics

Dell Compaq Gateway

1997 1996 1997 1996 1997 1996
Sales 12,327 7,759 24,584 20,009 6,293 5,035
Cost of sales 9,605 6,093 17,833 14,855 5,217 4,099
Interest expense 3 7 168 106 164 102
Taxes 424 216 903 565 94 132
Net income 944 518 1,855 1,318 110 251

Accounts receivable 1,486 903 2,891 3,718 511 450

Inventories 233 251 1,570 1,267 249 278
Total assets 4,268 2,993 14,631 12,331 2,039 1,673

Required
1. Calculate the return on sales and return on assets for each company for both 1996
and 1997. Use year-end balance sheet values. What can you conclude from these
ratios?
2. Calculate the accounts receivable turnover and the inventory turnover for each
company for both 1996 and 1997. Use year-end balance sheet values. What can
you conclude from these ratios?

18-16 Return on assets and equity Randolph Company has total assets of
$12,000,000 and a debt ratio of 30%. Interest expense is $360,000, and return on av-
erage total assets is 12%. The company has no preferred stock. Ignore taxes.

Required
1. Determine income, average stockholders equity, and ROE.
2. Suppose that sales have been $10,800,000 annually and are expected to continue
at this level. If the company could increase its ROS by one percentage point, what
would be its income, ROA, and ROE?
3. Refer to the original data and your answers to requirement 1. Suppose that
Randolph retires $1,800,000 in debt and therefore saves interest expense of
$180,000 annually. The company would issue additional common stock in the
amount of $1,800,000 to finance the retirement. Total assets would remain at
$12,000,000. What would be the income, ROA, and ROE?

18-17 Effects of transactionsreturns ratios Indicate the effects of each of the fol-
lowing transactions on the companys (a) ROS, (b) ROA, and (c) EPS. There are three
possible answers: (+) increase, () decrease, and (0) no effect. Before each transac-
tion takes place, the ratios are as follows: (a) ROS, 10%; (b) ROA, 5%; (c) EPS, $0.25.

Effects on
(a) (b) (c)
ROS ROA EPS
1. Sell a plant asset for cash, at twice
the assets book value. ___ ___ ___
2. Declare and issue a stock dividend. ___ ___ ___
3. Purchase inventory on account. ___ ___ ___
4. Purchase treasury stock for cash. ___ ___ ___
5. Acquire land by issuing common stock. ___ ___ ___

18-18 Ratios The financial statements for Massin Company, a merchandising

company, follow (in thousands of dollars). Massin has 1,000,000 common shares
 Chapter Eighteen Analyzing Financial Statements 823

outstanding. The price of the stock is $8. Massin declared dividends of $0.10 per
share. The balance sheet at the end of 20X1 showed approximately the same
amounts as that at the end of 20X2.

Massin Company, Income Statement for 20X2

Sales $4,700
Cost of goods sold 2,300
Gross profit $2,400
Operating expenses:
Depreciation $ 320
Other 1,230
Total 1,550
Income before interest and taxes $ 850
Interest expense 150
Income before taxes $ 700
Income taxes 280
Net income $ 420

Massin Company, Balance Sheet at December 31, 20X2

Assets Equities
Cash $ 220 Accounts payable $ 190
Accounts receivable 440 Accrued expenses 180
Inventory 410 Total current liabilities $ 370
Total current assets $ 1,070 Long-term debt 1,960
Plant and equipment 5,600 Common stock 1,810
Accumulated depreciation (2,100) Retained earnings 430
Total assets $ 4,570 Total equities $4,570

Required
Calculate the following ratios.

1. Current ratio.
2. Acid-test ratio.
3. Accounts receivable turnover.
4. Inventory turnover.
5. Gross profit ratio.
6. ROS.
7. ROA.
8. ROE.
9. EPS.
10. PE ratio.
11. Dividend yield.
12. Payout ratio.
13. EVA, assuming a 10% cost of capital.
14. Debt ratio.
15. Times interest earned.
16. Cash flow to total debt.
 824 Part Five Special Topics

PROBLEMS

CHAPTER
18-19 Analyzing ROE (adapted from a paper by Professor William E. Ferrara)
11 Chapter 11 introduced the idea of separating the components of ROI as follows:

net income sales

ROI =
sales investment

Applying this separation to the calculation of return on stockholders equity, we

could express ROE as

net income sales

ROE =
sales stockholders equity

This separation is less enlightening than it might be, however, because net income
combines the effects of financing choices (leverage) with the operating results.
Letting total assets/stockholders equity stand as a measure of financial leverage, we
can also express return on stockholders equity as follows:

net income sales total assets

ROE =
sales total assets stockholders equity

Sales and total assets cancel out, leaving the ratio net income/stockholders equity.
The three-factor expression allows the analyst to look at operations (margin
turnover, the first two terms) separately from financing (the last term).
The separation is not perfect because interest (financing expense) is included in
calculating net income, but the expansion is adequate for many purposes. Thus, the
product of the first two terms is a measure of operating efficiency, while the third is
a measure of leverage and therefore of financial risk.
The following data summarize results for three companies.

Company Results (in thousands of dollars)

A B C
Sales $4,500 $6,000 $5,000
Net income $450 $400 $480
Total assets $4,500 $4,500 $4,400
Stockholders equity $3,000 $2,000 $4,000
ROE 15% 20% 12%

Required
Calculate ROE for each company using the three-factor expression and comment on
the results. You should be able to draw tentative conclusions about the relative op-
erating and financing results of the companies.

18-20 Current asset activity The treasurer of Billingsgate Company has asked for
your assistance in analyzing the companys liquidity. She provides the following
data, in millions of dollars.

20X3 20X2 20X1

Total sales $481 $440 $395
Cost of goods sold 322 290 245
Accounts receivable at year end 64 48 31
Inventory at year end 51 44 38
Accounts payable at year end 36 29 28
 Chapter Eighteen Analyzing Financial Statements 825

Required
1. Compute accounts receivable turnover for 20X2 and 20X3.
2. Compute days sales in accounts receivable at the end of 20X2 and 20X3.
3. Compute inventory turnover for 20X2 and 20X3.
4. Compute days sales in inventory at the end of 20X2 and 20X3.
5. Comment on the trends in the ratios. Do the trends seem to be favorable or unfa-
vorable?

18-21 Constructing financial statements from ratios The following information is

available concerning Warnock Companys expected results in 20X2 (in thousands of
dollars). Turnovers are based on year-end values.

Required
Fill in the blanks.

Return on sales 6%
Gross profit percentage 40%
Inventory turnover 4 times
Receivables turnover 5 times
Current ratio 3 to 1
Ratio of total debt to total assets 40%

Condensed Income Statement

Sales $ 900
Cost of sales _____
Gross profit _____
Operating expenses _____
Net income $_____

Condensed Balance Sheet

Cash $ 30 Current liabilities $______
Receivables $______ Long-term debt ______
Inventory ______ Stockholders equity ______
Plant and equipment 670
Total $______ Total $______

18-22 Effects of transactions on ratios Indicate the effects of each of the following
transactions on the companys current ratio, acid-test ratio, and debt ratio. There are
three possible answers: increase (+), decrease (), and no effect (0). Before each
transaction takes place, the current ratio is greater than 1 to 1 and the acid-test ratio
is less than 1 to 1.

Effects on
Current Acid-Test Debt
Ratio Ratio Ratio
Example: An account payable is paid. +
1. Bought inventory for cash. _______ _______ _______
2. A sale is made on account; cost of
sales is less than selling price. _______ _______ _______
3. Issued long-term bonds for cash. _______ _______ _______
4. Sold land for cash at its
book value. _______ _______ _______
826 Part Five Special Topics

Effects on
Current Acid-Test Debt
Ratio Ratio Ratio
5. Marketable securities held as temporary
investments are sold at a gain. _______ _______ _______
6. Issued common stock in exchange for
plant assets. _______ _______ _______
7. Collected an account receivable. _______ _______ _______
Issued long-term debt for
plant assets. _______ _______ _______
9. Declared, but did not pay, a cash
dividend. _______ _______ _______
10. Paid the dividend in item 9. _______ _______ _______
11. Paid a short-term bank loan. _______ _______ _______
12. Recorded depreciation expense. _______ _______ _______

18-23 Comparisons of companies Condensed financial statements for Genco

Company and Rella Company appear on the bottom of the following page (in thou-
sands of dollars). Both companies are in the same industry and use the same ac-
counting methods. Balance sheet data for both companies were the same at the end
of 20X1 as at the end of 20X2.

Required
On the basis of the data given, answer the following questions. Support your an-
swers with whatever calculations you believe appropriate.
1. Which company seems to be more liquid?
2. Which company seems to be more profitable? Suppose cost of capital is 12% for
both companies.
3. Which company seems to be more solvent?
4. Which stock seems to be a better buy?

18-24 Effects of transactionsselected ratios In the following exhibit, several

transactions or events are listed in the left-hand column and the names of various ra-
tios and the value of that ratio before the associated transaction are listed in the
right-hand column. Indicate the effect of the transaction on the specified ratio. There
are three possible answers: (+) increase, () decrease, and (0) no effect.

Effect
Transaction on Ratio
1. Write off an uncollectible
account receivable. _____ Current ratio of 3 to 1
2. Sell merchandise on account, 42 days sales in accounts
at less than normal price. _____ receivable
3. Borrow cash on a
short-term loan. _____ Acid-test ratio of 0.9 to 1
4. Write off an uncollectible
account receivable. _____ Return on sales of 18%
5. Sell treasury stock at a
price greater than its cost. _____ Return on equity of 20%
6. Acquire plant asset by
issuing long-term note. _____ Debt ratio of 40%
7. Record accrued salaries
payable. _____ Times interest earned of 3.2
 Chapter Eighteen Analyzing Financial Statements 827

Effect
Transaction on Ratio
8. Record depreciation on
plant assets. _____ Cash flow to debt ratio of 60%
9. Return inventory items to
supplier for credit. _____ Inventory turnover of 8 times
10. Acquire plant assets by
issuing common stock. _____ Debt ratio of 60%

Balance Sheets, End of 20X2

Genco Rella
Company Company
Assets
Cash $ 185 $ 90
Accounts receivable 215 170
Inventory 340 220
Plant and equipment (net) 850 810
Total assets $1,590 $1,290

Equities
Accounts payable $ 150 $ 140
Other current liabilities 80 90
Long-term debt 300 500
Common stock 700 300
Retained earnings 360 260
Total equities $1,590 $1,290

Income Statements for 20X2

Genco Rella
Company Company
Sales $3,050 $2,800
Cost of goods sold 1,400 1,350
Gross profit $1,650 $1,450
Operations expenses:
Depreciation $ 280 $ 240
Other 1,040 900
Total $1,320 $1,140
Income before interest and taxes $ 330 $ 310
Interest expense 30 55
Income before taxes $ 300 $ 255
Income taxes at 40% 120 102
Net income $ 180 $ 153

Earnings per share $0.90 $0.77

Dividends per share $0.40 $0.20
Market price of common stock $12.00 $11.50
828 Part Five Special Topics

18-25 Constructing financial statements using ratios The following data are
available for Wasserman Pharmaceutical Company as of December 31, 20X2 and for
the year ended.

Current ratio 2.5 to 1

Days sales in accounts receivable 55 days
Inventory turnover 4 times
Debt ratio 40%
Current liabilities $450,000
Stockholders equity $1,500,000
Return on sales 10%
Return on common equity 20%
Gross profit ratio 40%

Wasserman has no preferred stock, no marketable securities, and no prepaid ex-

penses. Beginning-of-year balance sheet figures are the same as end-of-year figures.
The only noncurrent assets are plant and equipment.

Required
Prepare a balance sheet as of December 31, 20X2 and an income statement for 20X2
in as much detail as you can with the available information. Round all figures to the
nearest $1,000.

18-26 Dilution of EPS Boston Tarrier Company has been very successful in recent
years, as shown by the following data.

20X2 20X3
Net income $6,200,000 $8,600,000
Preferred stock dividends 800,000 800,000
Earnings available for common stock $5,400,000 $7,800,000

The treasurer of the company is concerned because he expects holders of the com-
panys convertible preferred stock to exchange their shares for common shares early
in the coming year. All of the companys preferred stock is convertible, and the num-
ber of common shares issuable on conversion is 400,000. Throughout 20X2 and
20X3 the company had 600,000 shares of common stock outstanding.

Required
1. Compute basic EPS for 20X2 and 20X3.
2. Compute diluted EPS for 20X2 and 20X3.

18-27 Inventory turnover and return on equity Timmons Company is presently

earning net income of $400,000 per year, which gives a 10% ROE. The president be-
lieves that inventory can be reduced with tighter controls on buying. Any reduction
of inventory frees cash, which would be used to pay a dividend to stockholders.
Thus, stockholders equity would drop by the same amount as inventory.
Inventory turnover is 3 times per year. Cost of goods sold is running at $3,600,000
annually. The president believes that careful management can increase turnover to
5 times. He also believes that sales, cost of goods sold, and net income will remain
at their current levels.

Required
1. Determine Timmonss average inventory.
 Chapter Eighteen Analyzing Financial Statements 829

2. Determine Timmonss average inventory if turnover could be increased to 5 times

per year.
3. Determine ROE if Timmons can increase turnover and reduce stockholders equity
by the amount of the reduction in investment in inventory.

18-28 Ratiosindustry averages The president of Brewster Company has been

concerned about its operating performance and financial strength. She has obtained,
from a trade association, the averages of certain ratios for the industry. She gives
you these ratios and the companys most recent financial statements (in thousands
of dollars). The balance sheet amounts were about the same at the beginning of the
year as they are now.

Brewster Company, Balance Sheet as of December 31, 20X1

Assets Equities
Cash $ 860 Accounts payable $ 975
Accounts receivable 3,210 Accrued expenses 120
Inventory 2,840 Taxes payable 468
Total current assets $ 6,910 Total current liabilities $ 1,563
Plant and equipment, net 7,090 Bonds payable, due 19X9 6,300
Common stock, no par 4,287
Retained earnings 1,850
Total assets $14,000 Total equities $14,000

Brewster Company, Income Statement for 20X1

Sales $11,800
Cost of goods sold 7,350
Gross profit $ 4,450
Operating expenses, including $650 depreciation 2,110
Operating profit $ 2,340
Interest expense 485
Income before taxes $ 1,855
Income taxes at 40% 742
Net income $ 1,113

Brewster has 95,000 shares of common stock outstanding, which gives earnings per
share of $11.72 ($1,113,000/95,000). Dividends are $5 per share and the market price
of the stock is $120. Average ratios for the industry are as follows:

Current ratio 3.8 to 1 Return on equity 17.5%

Quick ratio 1.9 to 1 Price-earnings ratio 12.3
Accounts receivable turnover 4.8 times Dividend yield 3.9%
Inventory turnover 3.6 times Payout ratio 38.0%
Return on sales 7.6% Debt ratio 50.0%
Return on assets 17.6% Times interest earned 6 times
Cash flow to total debt 25.0%

Required
1. Compute the ratios shown above for Brewster Company.
830 Part Five Special Topics

2. Prepare comments to the president indicating areas of apparent strength and

weakness for Brewster Company in relation to the industry.

18-29 Generating cash flows Humbert Company must make a $900,000 payment
on a bank loan at the end of March 20X2. At December 31, 20X1, Humbert had cash
of $125,000 and accounts receivable of $632,000. Estimated cash payments required
during the first three months of 20X2, exclusive of the payment to the bank, are
$645,000. Humbert expects sales to be $1,200,000 in the three-month period, all on
credit. Accounts receivable normally equal about 45 days sales.

Required
1. Determine the expected balance in accounts receivable at the end of March 20X2.
2. Determine whether the company will have enough cash to pay the bank loan on
March 31, 20X2.

CASES

18-30 Evaluation of trends and comparison with industry Comparative balance

sheets and income statements for Marcus Manufacturing Company appear on the fol-
lowing page (in thousands of dollars). Your boss, the chief financial analyst for
Hanmattan Bank, has asked you to analyze trends in the companys operations and fi-
nancing and to make some comparisons with the averages for the same industry. The
bank is considering the purchase of some shares of Marcus for one of its trust funds.
Selected data from the 20X2 balance sheet (in thousands of dollars) include the fol-
lowing:

Accounts receivable $ 510

Inventory (all finished goods) 620
Total assets 2,940
Stockholders equity 1,320

The following are averages for Marcuss industry.

Current ratio 2.7 to 1 Receivables turnover 8.5 times

Quick ratio 1.4 to 1 Inventory turnover 4.2 times
Debt ratio 52% Return on assets 15.0%
Price-earnings ratio 11.5 Return on equity 13.5%
Dividend yield 4.5% Return on sales 5.0%
Payout ratio 48.0%

Required
Compute the above ratios for Marcus for 20X3 and 20X4 and comment on the trends
in the ratios and on relationships to industry averages.

18-31 Trends in ratios As the chief investment officer of a large pension fund, you
must make many investing decisions. One of your assistants has prepared the fol-
lowing ratios for MBI Corporation, a large multinational manufacturer.
 Chapter Eighteen Analyzing Financial Statements 831

Marcus Manufacturing Company, Balance Sheets as of December 31

20X4 20X3
Assets
Cash $ 170 $ 180
Accounts receivable 850 580
Inventory (all finished goods) 900 760
Total current assets $1,920 $1,520
Plant and equipment, net 2,050 1,800
Total assets $3,970 $3,320

Equities
Current liabilities $ 812 $ 620
Long-term debt 1,640 1,300
Common stock 1,000 1,000
Retained earnings 518 400
Total equities $3,970 $3,320

Marcus Manufacturing Company, Income Statements

20X4 20X3
Sales $4,700 $4,350
Cost of goods sold 2,670 2,460
Gross profit $2,030 $1,890
Operating expenses 1,470 1,440
Income before interest and taxes $ 560 $ 450
Interest expense 130 100
Income before taxes $ 430 $ 350
Income taxes at 40% 172 140
Net income $ 258 $ 210

Earnings per share $2.58 $2.10

Market price of stock at year end $32.00 $28.00
Dividends per share $0.96 $0.80

Industry
Average
All Years 20X3 20X2 20X1
Current ratio 2.4 2.6 2.4 2.5
Quick ratio 1.6 1.55 1.6 1.65
Receivable turnover 8.1 7.5 7.9 8.3
Inventory turnover 4.0 4.3 4.2 4.0
Debt ratio 43.0% 38.0% 41.3% 44.6%
Return on assets 17.8% 19.1% 19.4% 19.5%
Return on equity 15.3% 15.1% 15.6% 15.9%
Price-earnings ratio 14.3 13.5 13.3 13.4
Times interest earned 8.3 9.7 9.5 8.9
Earnings per share growth rate 8.4% 7.1% 6.9% 7.0%
832 Part Five Special Topics

Required
What is your decision in the following cases? Give your reasons.
1. Granting a short-term loan to MBI.
2. Buying long-term bonds of MBI on the open market. The bonds yield 7%, which
is slightly less than the average for bonds in the industry.
3. Buying MBI common stock.

18-32 Financial planning with ratios The treasurer of SmartStore, Inc., a large
chain of convenience stores, has been trying to develop a financial plan. In conjunc-
tion with other managers, she has developed the following estimates, in millions of
dollars.

20X1 20X2 20X3 20X4

Sales $100 $120 $150 $210
Plant assets, net 80 95 110 125

In addition, for planning purposes she is willing to make the following estimates and
assumptions about other results.

Cost of goods sold as a percentage of sales 55%

Return on sales 15%
Dividend payout ratio 20%
Turnovers based on year-end values:
Cash and accounts receivable 5 times
Inventory 4 times
Required current ratio 3 to 1
Required ratio of long-term debt to stockholders equity 50%

At the beginning of 20X1 the treasurer expects stockholders equity to be $60 million
and long-term debt to be $30 million.

Required
Prepare pro forma balance sheets and any supporting schedules you need for the
end of each of the next four years. Determine how much additional common stock,
if any, the company will have to issue each year if the treasurers estimates and as-
sumptions are correct.

18-33 Leverage Mr. Harmon, treasurer of Stokes Company, has been considering
two plans for raising $2,000,000 for plant expansion and modernization. One choice
is to issue 9% bonds. The other is to issue 25,000 shares of common stock at $80 per
share. The modernization and expansion is expected to increase operating profit, be-
fore interest and taxes, by $320,000 annually. Depreciation of $200,000 is included in
the $320,000. Condensed financial statements for 20X2 follow (in thousands of dol-
lars).

Stokes Company, Balance Sheet as of December 31, 20X2

Assets Equities
Current assets $ 3,200 Current liabilities $ 1,200
Plant and equipment, net 7,420 Long-term debt, 7% 3,000
Other assets 870 Stockholders equity 7,290
Total assets $11,490 Total equities $11,490
 Chapter Eighteen Analyzing Financial Statements 833

Stokes Company, Income Statement for 20X2

Sales $8,310
Cost of sales $5,800
Operating expenses 1,200
Total 7,000
Operating profit $1,310
Interest expense 210
Income before taxes $1,100
Income taxes at 40% 440
Net income $ 660

Earnings per share* $6.60

Dividends per share $3.30
* Based on 100,000 outstanding shares

Mr. Harmon is concerned about the effects of issuing debt. The average debt ratio for
companies in the industry is 42%. He believes that if this ratio is exceeded, the PE
ratio of the stock will fall to 11 because of the potentially greater risk. If Stokes in-
creases its common equity substantially by issuing new shares, he expects the PE
ratio to increase to 12.5. He also wonders what will happen to the dividend yield
under each plan. The company follows the practice of paying dividends equal to 50%
of net income.

Required
1. For each financing plan, calculate the debt ratio that the company would have
after the securities (bonds or stocks) are issued.
2. For each financing plan, determine the expected net income in 20X3, expected
EPS, and the expected market price of the common stock.
3. Calculate, for each financing plan, the dividend per share that Stokes would pay
following its usual practice and the yield that would be obtained at the market
prices from your answer to requirement 2.
4. Suppose that you now own 100 shares of Stokes Company. Which alternative
would you prefer the company to use? Why?