Chapter 6

M 6-15 a. Accounts Receivable Turnover for the current year Procter & Gamble.................... $83,503 / [($6,761+$6,629) / 2] = 12.47 Colgate-Palmolive................... $13,790 / [($1,681+$1,523) / 2] = 8.61 b. P&G turns its accounts receivable much faster than Colgate-Palmolive. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative bargaining strength vis--vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power with WalMart than does the smaller Colgate-Palmolive. M 6-18 a. Inventory Turnover rates for 2008 ANF......................................... TJX.......................................... $1,238 / [ ($333 + $427) / 2 ] = 3.26 $14,082 / [($2,737+$2,582) /2] = 5.29

b. TJXs inventory turnover rate is higher than ANFs. TJX concentrates on the value-priced end of the clothing spectrum. Thus, it realizes a lower profit margin that must be offset with higher turnover to yield an acceptable return on net operating assets (see discussion of profitability and turnover in Module 4). c. Inventory turnover improves as the volume of goods sold increases relative to the dollar value of goods available for sale. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels. Companies can lower inventory levels by reducing the depth and breadth of product lines carried (such as not carrying every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed, and marking down goods for sale at the end of product seasons.

P6-38 Best Buy (a retailer) reports a much higher receivables turnover rate than do the manufacturers, Caterpillar and Harley-Davidson. The likely reason for this is that retail sales are usually via cash, check, or credit cards (which are like cash for the retailers). Recall that the turnover ratio includes credit sales, but, because most firms do not report credit sales, we are forced to use total sales when we calculate the turnover ratio. Manufacturers, on the other hand, usually sell to retailers on credit and the accounts are not collected for a much longer period of time. CAT and HOG both have finance subsidiaries that provide loan and lease financing. The longer term of these receivables reduces turnover rates.
a.

Harley-Davidsons relatively higher inventory turnover rate, compared with Caterpillar, most likely reflects the fact that demand is high for Harley-Davidsons products and the motorcycles are sold before production begins, thus minimizing finished goods inventories. CAT, on the other hand, builds a relatively smaller number of high cost machines that likely take a much longer period of time to manufacture.
b.

Oracle is a software development and service company and does not carry inventories of products for sale. Carnival, the cruise ship line, is capital-intensive. Microsoft, on the other hand, requires relatively few PPE assets to support its operations. Microsofts R&D costs are expensed under GAAP rather than capitalized as PPE. Thus, Microsofts PPE turnover is much higher than Carnivals.
c.

The relative asset turnover rates reported generally conform to our expectations across industries. Those industries that sell on credit, rather than using credit cards, or that normally stock inventories for production and sale, or that require substantial investment in long-term assets yield much lower receivable, inventory, and PPE turnover rates respectively. These lower turnover rates must be accompanied by higher profit margins and/or higher financial leverage to yield a satisfactory return on net operating assets. Generally, we expect the following:
d.

Industry Retailing............... Manufacturing.....

Receivables Turnover

Inventory Turnover

PPE Turnover

P6-40
($ in thousands, consistent with Intuits financial statements)

Gross receivables as of 2008 are $127,230 + $15,636 = $142,866. Gross receivables as of 2007 are $131,691 + $15,248 = $146,939.
a.

Estimated uncollectible accounts as a percentage of gross accounts receivable are: 10.9%, computed as ($15,636 / $142,866) in 2008 10.4%, computed as ($15,248 / $146,939) in 2007
b.

The 2008 allowance for uncollectible accounts increased slightly as a percentage of gross accounts receivable the allowance increased despite a decrease in gross accounts receivable. This could be because there is greater uncertainty about the collectability of receivables in general, or one or more large accounts are in arrears.

c.

Average collection period (days sales in accounts receivable) is: $142,866 / ($3,071,000 / 365) = 16.98 days Intuits sales to consumers are primarily via on-line purchases using credit cards for payment. Its average collection period for receivables will, therefore, be low for this portion of its business. Service revenues are likely on account, and the collection period is likely to be longer for this segment of Intuits business. Its overall average collection period for accounts receivable is an average of these lines of business. Intuits allowance seems high over 10% in both 2007 and 2008. To assess this, we would compare Intuits ratios to the allowances of Intuits competitors. It could be that the industry suffered an economic downturn in 2007 and 2008 and customers are having difficulty paying.
d.

$3,071,000 = 21.19 The receivables turnover rate is $142,866 $146,939 + 2

P6-40continued Intuits allowance for uncollectible accounts is increased by the provision (additions charged to expense) and is decreased by writeoffs of accounts receivable (deductions). Over the three-year period covered by the table, Intuit has increased its allowance account by a cumulative amount of $38,234 ($14,269 + $14,743 + $9,222). It has written off a cumulative total of $37,565 ($13,881 + $11,027 + $12,657). The allowance account has, therefore, increased by $669 ($38,234 - $37,565), from $14,967 to $15,636. The increase charged to expense has slightly exceeded its write-offs.
e.

As mentioned above, this increase might be due to customers weakening credit quality. It might also be the case that Intuit is conservative and is intentionally depressing its current profit. An inflated allowance can be used to absorb future receivable write-offs with no impact on future profit, or can be reversed in a future year to provide an immediate reduction in expense and consequent increase in profit. Either way, if the allowance account is inflated, the effect is to shift profit from the current period into one or more future periods. This does not appear to be the case for Intuit since the additions to the allowance account have nearly mirrored write-offs of accounts receivable.

P6-41
($ millions)

Dow uses LIFO inventory costing for 34% of inventories at December 31, 2007. As of 2007, the LIFO inventory reserve is $1,511 million. Thus, cumulatively, pretax income has been reduced by $1,511 million because Dow uses LIFO. Assuming a tax rate of 35%, Dow has saved taxes of $528.9 million ($1,511 million 35%), cumulatively. During 2007, the LIFO reserve increased by $419 million ($1,511 million - $1,092 million), saving the company $146.65 million ($419 million 35%) in taxes. This tax saving increased operating cash flow by that same amount.
a. b.

The inventory turnover rate for 2007 is 7.17 (computed as

$46,400 $6,885+ $6,058 ). 2

The average inventory days outstanding for 2007 is 54.16 ($6,885 / [$46,400/ 365 days]). DOW is a manufacturer, thus, it requires a certain level of raw materials and continually maintains inventories in production and awaiting delivery. The average inventory days outstanding does not appear excessive. We could usefully compare both of these ratios to those of other manufacturers in the same industry as DOW to make a more informed comparison. Since the overall cost of its inventories has been increasing, DOWs reduction of inventory quantities resulted in the matching of lower-cost inventories against higher current selling prices. This increased its income by $321 million in 2007, $97 million in 2006, and $110 million in 2005. This reduction in inventory quantities is called LIFO liquidation.
c.

P6-42 Average useful life = Depreciable asset cost / Depreciation expense = ($15,597,801 - $494,021 - $1,121,328) / $1,072,855 = 13.03 years
a.

(Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not yet depreciable).

The footnote indicates that buildings have estimated useful lives ranging from 10-50 years (27-year average) and Equipment from 3-20 years (11-year average). Thus, the estimate of 13.0 years rests between these two reported values.
b.

Percent used up = Accumulated depreciation/ Depreciable asset cost = $8,079,652 / ($15,597,801 - $494,021 - $1,121,328) = 57.8%

(Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not depreciable).

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. Abbott Labs 57.8% is slightly higher than this level, but not high enough to cause concern that it will need markedly higher capital expenditures in the near future to replace aging assets. P6-43
$ millions

a.

PPE turnover for 2007 is: $8,897 / [($2,871 + $2,669) / 2] = 3.21.

This turnover is lower than the 5.03 median for all publicly traded companies. This indicates that Rohm and Haas is more capital intensive than the median publicly traded company. Rohm and Haas balance sheet does not reflect all of its operating assets. For example, under generally accepted accounting principles, the company must expense most, if not all, of its R&D expenditures. Substantial R&D costs not reflected on the balance sheet would yield understated PPE assets and thus, an overstated PPE turnover rate the sales resulting from the R&D investments are included in the numerator of PPE turnover but the R&D related assets are excluded from the denominator.

Rohm and Haas average asset depreciation, can be estimated as

b.

life,

assuming

straight-line

Depreciable asset cost / Depreciation expense ($8,779 - $146*- $352* - $271*) / $412 = 19.44 years *Note:
We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not yet depreciable.

c. As of 2007, the companys plant assets were approximately 73.8% used up, which is computed as follows: Accumulated depreciation / Depreciable asset cost $5,908 / ($8,779 - $146*- $352* - $271*) = 73.76% *Note:
We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not depreciated.

If plant assets are replaced at a constant rate, we would expect those assets to be about 50% used up, on average. A substantially higher percentage used up indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively impact future cash flows. Rohm & Haas depreciable assets appear to be substantially used up based on this analysis. d. Plant assets are deemed to be impaired if the undiscounted expected future cash flows from those assets are not sufficient to recover their net book value. That is, the sum of the undiscounted future cash flows is less than the net book value. If impaired, the plant assets are written down to their fair value, which is typically, the discounted value of the future expected cash flows. An asset impairment charge (such as Rohm and Haas $24 million charge in 2007) reduces net income, but has no effect on current period cash flows because an impairment charge is a noncash expense. Moreover, the impairment charge is not deductible for tax purposes until the asset is disposed of, that is, until the loss is realized. Since asset impairment charges are nonrecurring, we would be justified in treating them as transitory (operating) items for analysis purposes.