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Unformatted text preview: CHAPTER2FINANCIALSTATEMENTSAND ANALYSISLEARNINGLG1Review the contents of the stockholders reportand the procedures for consolidating internationalfinancial statements.LG2Understand who uses financial ratios, andhow.LG3LG5LG6GOALSUse ratios to analyze a firms profitability and itsmarket value.Use a summary of financial ratios and the DuPontsystem of analysis to perform a complete ratioanalysis.Use ratios to analyze a firms liquidity andactivity.LG4Discuss the relationship between debt andfinancial leverage and the ratios used to analyzea firms debt.Across the Disciplines WHY THIS CHAPTER MATTERS TO YO UAccounting: You need to understand the stockholders reportand preparation of the four key financial statements; how firmsconsolidate international financial statements; and how to calculate and interpret financial ratios for decision making.Information systems: You need to understand what data areincluded in the firms financial statements in order to designsystems that will supply such data to those who prepare thestatements and to those in the firm who use the data for ratiocalculations.Management: You need to understand what parties are interested in the annual report and why; how the financial statements will be analyzed by those both inside and outside the firmto assess various aspects of performance; the caution that40should be exercised in using financial ratio analysis; and howthe financial statements affect the value of the firm.Marketing: You need to understand the effects your decisionswill have on the financial statements, particularly the incomestatement and the statement of cash flows, and how analysis ofratios, especially those involving sales figures, will affect thefirms decisions about levels of inventory, credit policies, andpricing decisions.Operations: You need to understand how the costs of operations are reflected in the firms financial statements and howanalysis of ratios, particularly those involving assets, cost ofgoods sold, or inventory, may affect requests for new equipment or facilities.HOME DEPOTBUILDING STRONGFINANCIALSinancial reporting is no longer the primary responsibility of the chief financial officer (CFO). Therole of todays CFO, a key member of the executive team, has broadened to include strategicplanning and, at many companies, information management. Managing a companys financialoperations takes many different skills. Financial planning, operations, and analysis; treasury operations (raising funds and managing cash); business acquisition and valuation; tax planning; andinvestor relations are also under his or her control.Home Depot CFO and treasurer Carol Tom reports directly to chief executive officer RobertL. Nardelli. She works closely with him and with Dennis J. Carey, an executive vice president andthe chief strategy officer, to guide the giant home improvement retailers future growth. Alongwith her strategic responsibilities, Tom chooses the key financial measurements on which shewants managers to focus. These are tied to the economic climate. When the economy wasstrong, her objective was improving the companys return on investment (ROI). By late 2001, HomeDepots ROI was 16.0 percent, compared to 14.7 percent for the home improvement retail industry,6.7 percent for the services sector, and 10.2 percent for the S&P 500.In 2001s slower economy, the emphasis shifted to activity ratios that measure how quicklyaccounts are converted into cash. Particularly important to a retail chain are inventory turnover,receivables collection period, and accounts payable periods. Home Depot hired consultants tobenchmark its financial operations with other best-in-class companies. Were looking for processing efficiencies, Tom says. Improved new-store productivity and lower pre-opening costsper store, together with attention to cost control, are boosting margins. In the third quarter of2001, when many companies reported earnings drops, Home Depots net income and earnings pershare rose over the same period in 2000.The companys measures of debt also indicate a strong financial position. Its ratio of debt tototal capital indicates that only about 10 percent of its total long-term financing is debt, a very lowdegree of indebtedness. This strong position gives Home Depot more flexibility to pursue newprojects, such as its new high-end line of stores called Expo, and more opportunities to raisefunds from banks, which use ratio analysis to assess creditworthiness.In this chapter you will learn how to analyze financial statements using financial ratios.F4142PART 1Introduction to Managerial FinanceLG12.1 The Stockholders Reportgenerally acceptedaccounting principles (GAAP)The practice and procedureguidelines used to prepare andmaintain financial records andreports; authorized by theFinancial Accounting StandardsBoard (FASB).Financial AccountingStandards Board (FASB)The accounting professionsrule-setting body, whichauthorizes generally acceptedaccounting principles (GAAP).Securities and ExchangeCommission (SEC)The federal regulatory body thatgoverns the sale and listing ofsecurities.Every corporation has many and varied uses for the standardized records andreports of its financial activities. Periodically, reports must be prepared for regulators, creditors (lenders), owners, and management. The guidelines used to prepare and maintain financial records and reports are known as generally acceptedaccounting principles (GAAP). These accounting practices and procedures areauthorized by the accounting professions rule-setting body, the FinancialAccounting Standards Board (FASB).Publicly owned corporations with more than $5 million in assets and 500 ormore stockholders1 are required by the Securities and Exchange Commission(SEC)the federal regulatory body that governs the sale and listing of securitiesto provide their stockholders with an annual stockholders report. Theannual report summarizes and documents the firms financial activities during thepast year. It begins with a letter to the stockholders from the firms presidentand/or chairman of the board.The Letter to Stockholdersstockholders reportAnnual report that publiclyowned corporations must provideto stockholders; it summarizesand documents the firmsfinancial activities during thepast year.WWWThe letter to stockholders is the primary communication from management. Itdescribes the events that are considered to have had the greatest impact on thefirm during the year. It also generally discusses management philosophy, strategies, and actions, as well as plans for the coming year. Links at this booksWeb site (www.aw.com/gitman) will take you to some representative letters tostockholders.letter to stockholdersTypically, the first element of theannual stockholders report andthe primary communication frommanagement.The Four Key Financial StatementsThe four key financial statements required by the SEC for reporting to shareholders are (1) the income statement, (2) the balance sheet, (3) the statement ofretained earnings, and (4) the statement of cash flows.2 The financial statementsfrom the 2003 stockholders report of Bartlett Company, a manufacturer ofmetal fasteners, are presented and briefly discussed.Income Statementincome statementProvides a financial summary ofthe firms operating resultsduring a specified period.The income statement provides a financial summary of the firms operating resultsduring a specified period. Most common are income statements covering a 1-yearperiod ending at a specified date, ordinarily December 31 of the calendar year.1. Although the Securities and Exchange Commission (SEC) does not have an official definition of publicly owned,these financial measures mark the cutoff point it uses to require informational reporting, regardless of whether thefirm publicly sells its securities. Firms that do not meet these requirements are commonly called closely ownedfirms.2. Whereas these statement titles are consistently used throughout this text, it is important to recognize that in practice, companies frequently use different titles. For example, General Electric uses Statement of Earnings ratherthan Income Statement and Statement of Financial Position rather than Balance Sheet. Bristol Myers Squibbuses Statement of Earnings and Retained Earnings rather than Income Statement. Pfizer uses Statement ofShareholders Equity rather than Statement of Retained Earnings.CHAPTER 2Hint Some firms, such asretailers and agricultural firms,end their fiscal year at the endof their operating cycle ratherthan at the end of the calendaryearfor example, retailers atthe end of January andagricultural firms at the end ofSeptember.Financial Statements and Analysis43Many large firms, however, operate on a 12-month financial cycle, or fiscal year,that ends at a time other than December 31. In addition, monthly income statements are typically prepared for use by management, and quarterly statementsmust be made available to the stockholders of publicly owned corporations.Table 2.1 presents Bartlett Companys income statements for the years endedDecember 31, 2003 and 2002. The 2003 statement begins with sales revenuethe total dollar amount of sales during the periodfrom which the cost of goodssold is deducted. The resulting gross profits of $986,000 represent the amountremaining to satisfy operating, financial, and tax costs. Next, operating expenses,which include selling expense, general and administrative expense, lease expense,TABLE 2.1Bartlett Company IncomeStatements ($000)For the years endedDecember 312003$3,074Sales revenueLess: Cost of goods sold2002$2,5671,711$ 986$ 856$ 100Gross profits2,088$ 108194187Less: Operating expensesSelling expenseGeneral and administrative expensesLease expensea35Total operating expenseOperating profitsLess: Interest expenseNet profits before taxesLess: Taxes (rate29%)bNet profits after taxesLess: Preferred stock dividends35239223$ 568$ 553$ 418Depreciation expense$ 3039391$ 325$ 2129464$ 231$ 1481010Earnings available for common stockholders$ 221$ 138Earnings per share (EPS)c$ 2.90$ 1.81Dividend per share (DPS)d$ 1.29$ 0.75aLeaseexpense is shown here as a separate item rather than being included aspart of interest expense, as specified by the FASB for financial-reporting purposes. The approach used here is consistent with tax-reporting rather thanfinancial-reporting procedures.bThe 29% tax rate for 2003 results because the firm has certain special taxwrite-offs that do not show up directly on its income statement.cCalculated by dividing the earnings available for common stockholders bythe number of shares of common stock outstanding76,262 in 2003 and76,244 in 2002. Earnings per share in 2003: $221,000 76,262 $2.90; in2002: $138,000 76,244 $1.81.dCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common stock outstanding. Dividends pershare in 2003: $98,000 76,262 $1.29; in 2002: $57,183 76,244 $0.75.44PART 1Introduction to Managerial Financedividend per share (DPS)The dollar amount of cashdistributed during the period onbehalf of each outstanding shareof common stock.and depreciation expense, are deducted from gross profits.3 The resulting operating profits of $418,000 represent the profits earned from producing and sellingproducts; this amount does not consider financial and tax costs. (Operatingprofit is often called earnings before interest and taxes, or EBIT.) Next, the financial costinterest expenseis subtracted from operating profits to find net profits (or earnings) before taxes. After subtracting $93,000 in 2003 interest, BartlettCompany had $325,000 of net profits before taxes.Next, taxes are calculated at the appropriate tax rates and deducted to determine net profits (or earnings) after taxes. Bartlett Companys net profits aftertaxes for 2003 were $231,000. Any preferred stock dividends must be subtractedfrom net profits after taxes to arrive at earnings available for common stockholders. This is the amount earned by the firm on behalf of the common stockholdersduring the period.Dividing earnings available for common stockholders by the number ofshares of common stock outstanding results in earnings per share (EPS). EPS represents the number of dollars earned during the period on behalf of each outstanding share of common stock. In 2003, Bartlett Company earned $221,000for its common stockholders, which represents $2.90 for each outstanding share.The actual cash dividend per share (DPS), which is the dollar amount of cash distributed during the period on behalf of each outstanding share of common stock,paid in 2003 was $1.29.Balance Sheetbalance sheetSummary statement of the firmsfinancial position at a given pointin time.current assetsShort-term assets, expected tobe converted into cash within 1year or less.current liabilitiesShort-term liabilities, expectedto be paid within 1 year or less.The balance sheet presents a summary statement of the firms financial positionat a given point in time. The statement balances the firms assets (what it owns)against its financing, which can be either debt (what it owes) or equity (what wasprovided by owners). Bartlett Companys balance sheets as of December 31 of2003 and 2002 are presented in Table 2.2. They show a variety of asset, liability(debt), and equity accounts.An important distinction is made between short-term and long-term assetsand liabilities. The current assets and current liabilities are short-term assets andliabilities. This means that they are expected to be converted into cash (currentassets) or paid (current liabilities) within 1 year or less. All other assets and liabilities, along with stockholders equity, which is assumed to have an infinite life,are considered long-term, or fixed, because they are expected to remain on thefirms books for more than 1 year.As is customary, the assets are listed from the most liquidcashdown tothe least liquid. Marketable securities are very liquid short-term investments, suchas U.S. Treasury bills or certificates of deposit, held by the firm. Because they arehighly liquid, marketable securities are viewed as a form of cash (near cash).Accounts receivable represent the total monies owed the firm by its customers oncredit sales made to them. Inventories include raw materials, work in process(partially finished goods), and finished goods held by the firm. The entry forgross fixed assets is the original cost of all fixed (long-term) assets owned by the3. Depreciation expense can be, and frequently is, included in manufacturing costscost of goods soldto calculategross profits. Depreciation is shown as an expense in this text to isolate its impact on cash flows.CHAPTER 2TABLE 2.2Financial Statements and AnalysisBartlett Company Balance Sheets ($000)December 31Assets20032002$ 363$ 2886851Current assetsCashMarketable securitiesAccounts receivable503365Inventories289300$1,223$1,004$2,072$1,903Total current assetsGross fixed assets (atcost)aLand and buildingsMachinery and equipment1,8661,693Furniture and fixtures358316Vehicles275314Other (includes financial leases)Total gross fixed assets (at cost)Less: Accumulated depreciation9896$4,669$4,3222,2952,056Net fixed assets$2,374$2,266Total assets$3,597$3,270$ 382$ 2707999Liabilities and Stockholders EquityCurrent liabilitiesAccounts payableNotes payableAccrualsTotal current liabilitiesLong-term debt (includes financial leases)bTotal liabilities159114$ 620$ 483$1,023$ 967$1,643$1,450$ 200$ 200Stockholders equityPreferred stockcumulative 5%, $100 par, 2,000 sharesauthorized and issuedcCommon stock$2.50 par, 100,000 shares authorized, sharesissued and outstanding in 2003: 76,262; in 2002: 76,244191190Paid-in capital in excess of par on common stock428418Retained earningsTotal stockholders equityTotal liabilities and stockholders equityaIn1,1351,012$1,954$1,820$3,597$3,2702003, the firm has a 6-year financial lease requiring annual beginning-of-year payments of $35,000.Four years of the lease have yet to run.bAnnual principal repayments on a portion of the firms total outstanding debt amount to $71,000.cThe annual preferred stock dividend would be $5 per share (5% $100 par), or a total of $10,000annually ($5 per share 2,000 shares).4546PART 1Introduction to Managerial FinanceFOCUS ON PRACTICEExtraordinary? Not to the FASB!To most of us, the events of September 11, 2001, would certainlyqualify as extraordinary. The planecrashes that took thousands oflives, destroyed the World TradeCenter Towers, and damaged partof the Pentagon were circumstances well outside what weconsider ordinary. Yet, severalweeks after the tragedy theFinancial Accounting StandardsBoard (FASB) announced that theterrorist attack did not constitutean extraordinary eventat leastnot in accounting terms.As a result, companies willnot be able to separate costs andexpenses related to the disaster asextraordinary on their financialstatements. Those expenses willshow up as normal operating costsin the continuing operations section of the income statement.Hint Another interpretationof the balance sheet is that onone side are the assets that havebeen purchased to be used toincrease the profit of the firm.The other side indicates howthese assets were acquired,either by borrowing or byinvesting the owners money.long-term debtDebts for which payment is notdue in the current year.paid-in capital in excess of parThe amount of proceeds inexcess of the par value receivedfrom the original sale of commonstock.Explained Tim Lucas, chair of theFASB Emerging Issues Task Force,The task force understood thatthis was an extraordinary event inthe English-language sense of theword. But in the final analysis, wedecided it wasnt going to improvethe financial reporting system toshow it [separately].The FASB task force had prepared a draft document withguidelines on accounting for disaster-related costs as extraordinary. As they considered how toapply these recommendations,they realized that the impact of theattack was so far-ranging that itwas almost impossible to divide direct financial and economic effects from the weakening economic conditions prior toSeptember 11. Nor was it possibleto develop one set of guidelinesIn Practiceappropriate for all industries. FASBmembers were concerned thatcompanies would blame negativefinancial performance on the attacks when in fact the costs wereunrelated. As one member pointedout, almost every company was affected in some way. Because thewhole business climate changed,it almost made it ordinary.Companies will, however, beable to separate costs they believeto be attributable to September 11in the footnotes to financial statements and in managements discussion of financial results.Sources: Jennifer Davies, Will AttacksCover Up Weak Earnings? San DiegoUnion-Tribune (October 14, 2001), pp. H1, H6;Steve Liesman, Accountants, in a Reversal,Say Costs from the Attack Arent Extraordinary, Wall Street Journal (October 1, 2001),pp. C1-2; Keith Naughton, Out of the Ordinary, Newsweek (October 15, 2001), p. 9.firm.4 Net fixed assets represent the difference between gross fixed assets andaccumulated depreciationthe total expense recorded for the depreciation offixed assets. (The net value of fixed assets is called their book value.)Like assets, the liabilities and equity accounts are listed from short-term tolong-term. Current liabilities include accounts payable, amounts owed for creditpurchases by the firm; notes payable, outstanding short-term loans, typicallyfrom commercial banks; and accruals, amounts owed for services for which a billmay not or will not be received. (Examples of accruals include taxes due the government and wages due employees.) Long-term debt represents debt for whichpayment is not due in the current year. Stockholders equity represents the owners claims on the firm. The preferred stock entry shows the historical proceedsfrom the sale of preferred stock ($200,000 for Bartlett Company).Next, the amount paid by the original purchasers of common stock is shownby two entries: common stock and paid-in capital in excess of par on commonstock. The common stock entry is the par value of common stock. Paid-in capitalin excess of par represents the amount of proceeds in excess of the par valuereceived from the original sale of common stock. The sum of the common stock4. For convenience the term fixed assets is used throughout this text to refer to what, in a strict accounting sense, iscaptioned property, plant, and equipment. This simplification of terminology permits certain financial conceptsto be more easily developed.CHAPTER 2retained earningsThe cumulative total of allearnings, net of dividends, thathave been retained andreinvested in the firm since itsinception.Financial Statements and Analysis47and paid-in capital accounts divided by the number of shares outstanding represents the original price per share received by the firm on a single issue of commonstock. Bartlett Company therefore received about $8.12 per share [($191,000par $428,000 paid-in capital in excess of par) 76,262 shares] from the sale ofits common stock.Finally, retained earnings represent the cumulative total of all earnings, net ofdividends, that have been retained and reinvested in the firm since its inception. Itis important to recognize that retained earnings are not cash but rather have beenutilized to finance the firms assets.Bartlett Companys balance sheets in Table 2.2 show that the firms totalassets increased from $3,270,000 in 2002 to $3,597,000 in 2003. The $327,000increase was due primarily to the $219,000 increase in current assets. The assetincrease in turn appears to have been financed primarily by an increase of$193,000 in total liabilities. Better insight into these changes can be derived fromthe statement of cash flows, which we will discuss shortly.Statement of Retained Earningsstatement of retained earningsReconciles the net incomeearned during a given year, andany cash dividends paid, with thechange in retained earningsbetween the start and the end ofthat year.The statement of retained earnings reconciles the net income earned during agiven year, and any cash dividends paid, with the change in retained earningsbetween the start and the end of that year. Table 2.3 presents this statement forBartlett Company for the year ended December 31, 2003. The statement showsthat the company began the year with $1,012,000 in retained earnings and hadnet profits after taxes of $231,000, from which it paid a total of $108,000 in dividends, resulting in year-end retained earnings of $1,135,000. Thus the netincrease for Bartlett Company was $123,000 ($231,000 net profits after taxesminus $108,000 in dividends) during 2003.Statement of Cash Flowsstatement of cash flowsProvides a summary of the firmsoperating, investment, andfinancing cash flows andreconciles them with changes inits cash and marketable securities during the period.The statement of cash flows is a summary of the cash flows over the period ofconcern. The statement provides insight into the firms operating, investment,and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Bartlett Companys statement of cash flowsfor the year ended December 31, 2003, is presented in Table 2.4. Further insightinto this statement is included in the discussion of cash flow of in Chapter 3.TABLE 2.3Bartlett Company Statement of RetainedEarnings ($000) for the Year EndedDecember 31, 2003Retained earnings balance (January 1, 2003)$1,012Plus: Net profits after taxes (for 2003)231Less: Cash dividends (paid during 2003)Preferred stock($10)Common stock( 98)Total dividends paidRetained earnings balance (December 31, 2003)(108)$1,13548PART 1Introduction to Managerial FinanceTABLE 2.4Bartlett Company Statement of CashFlows ($000) for the Year EndedDecember 31, 2003Cash Flow from Operating ActivitiesNet profits after taxes$231Depreciation239Increase in accounts receivableDecrease in inventories( 138)a11Increase in accounts payable11245Increase in accrualsCash provided by operating activities$500Cash Flow from Investment ActivitiesIncrease in gross fixed assetsChange in business interests($347)0Cash provided by investment activities( 347)Cash Flow from Financing ActivitiesDecrease in notes payableIncrease in long-term debtsChanges in stockholdersequitybDividends paid($ 20)5611( 108)Cash provided by financing activities( 61)Net increase in cash and marketable securities$ 92aAsis customary, parentheses are used to denote a negative number, which in this case is acash outflow.bRetained earnings are excluded here, because their change is actually reflected in thecombination of the net profits after taxes and dividends paid entries.Notes to the Financial Statementsnotes to the financial statementsFootnotes detailing informationon the accounting policies,procedures, calculations, andtransactions underlying entriesin the financial statements.Included with published financial statements are explanatory notes keyed to therelevant accounts in the statements. These notes to the financial statements provide detailed information on the accounting policies, procedures, calculations,and transactions underlying entries in the financial statements. Common issuesaddressed by these notes include revenue recognition, income taxes, breakdownsof fixed asset accounts, debt and lease terms, and contingencies. Professionalsecurities analysts use the data in the statements and notes to develop estimates ofthe value of securities that the firm issues, and these estimates influence theactions of investors and therefore the firms share value.Consolidating International Financial StatementsSo far, weve discussed financial statements involving only one currency, the U.S.dollar. The issue of how to consolidate a companys foreign and domestic financial statements has bedeviled the accounting profession for many years. The cur-CHAPTER 2Financial Accounting StandardsBoard (FASB) Standard No. 52Mandates that U.S.-basedcompanies translate theirforeign-currency-denominatedassets and liabilities into dollars,for consolidation with the parentcompanys financial statements.This is done by using the currentrate (translation) method.WWWcurrent rate (translation) methodTechnique used by U.S.-basedcompanies to translate theirforeign-currency-denominatedassets and liabilities into dollars,for consolidation with the parentcompanys financial statements,using the exchange rate prevailing at the fiscal year ending date(the current rate).LG2Financial Statements and Analysis49rent policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which mandates that U.S.-based companies translate their foreigncurrency-denominated assets and liabilities into dollars, for consolidation withthe parent companys financial statements. This is done by using a techniquecalled the current rate (translation) method, under which all of a U.S. parentcompanys foreign-currency-denominated assets and liabilities are converted intodollar values using the exchange rate prevailing at the fiscal year ending date (thecurrent rate). Income statement items are treated similarly. Equity accounts, onthe other hand, are translated into dollars by using the exchange rate that prevailed when the parents equity investment was made (the historical rate).Retained earnings are adjusted to reflect each years operating profits or losses.Further details on this procedure can be found at the books Web site atwww.aw.com/gitman or in an intermediate accounting text.Review Questions212223Describe the purpose of each of the four major financial statements.Why are the notes to the financial statements important to professionalsecurities analysts?How is the current rate (translation) method used to consolidate a firmsforeign and domestic financial statements?2.2 Using Financial Ratiosratio analysisInvolves methods of calculatingand interpreting financial ratiosto analyze and monitor the firmsperformance.The information contained in the four basic financial statements is of major significance to various interested parties who regularly need to have relative measures of the companys operating efficiency. Relative is the key word here,because the analysis of financial statements is based on the use of ratios or relative values. Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firms performance. The basic inputs toratio analysis are the firms income statement and balance sheet.Interested PartiesHint Management shouldbe the most interested party ofthis group. Managers not onlyhave to worry abut thefinancial situation of the firm,but they are also criticallyinterested in what the otherparties think about the firm.Ratio analysis of a firms financial statements is of interest to shareholders, creditors, and the firms own management. Both present and prospective shareholdersare interested in the firms current and future level of risk and return, whichdirectly affect share price. The firms creditors are interested primarily in theshort-term liquidity of the company and its ability to make interest and principalpayments. A secondary concern of creditors is the firms profitability; they wantassurance that the business is healthy. Management, like stockholders, is concerned with all aspects of the firms financial situation, and it attempts to producefinancial ratios that will be considered favorable by both owners and creditors. Inaddition, management uses ratios to monitor the firms performance from periodto period.50PART 1Introduction to Managerial FinanceTypes of Ratio ComparisonsRatio analysis is not merely the calculation of a given ratio. More important isthe interpretation of the ratio value. A meaningful basis for comparison is neededto answer such questions as Is it too high or too low? and Is it good or bad?Two types of ratio comparisons can be made: cross-sectional and time-series.Cross-Sectional Analysiscross-sectional analysisComparison of different firmsfinancial ratios at the same pointin time; involves comparing thefirms ratios to those of otherfirms in its industry or to industryaverages.benchmarkingA type of cross-sectionalanalysis in which the firms ratiovalues are compared to those ofa key competitor or group ofcompetitors that it wishes toemulate.Hint Industry averages arenot particularly useful foranalyzing firms withmultiproduct lines. In the caseof multiproduct firms, it isdifficult to select theappropriate benchmarkindustry.EXAMPLECross-sectional analysis involves the comparison of different firms financialratios at the same point in time. Analysts are often interested in how well a firmhas performed in relation to other firms in its industry. Frequently, a firm willcompare its ratio values to those of a key competitor or group of competitors thatit wishes to emulate. This type of cross-sectional analysis, called benchmarking,has become very popular.Comparison to industry averages is also popular. These figures can be foundin the Almanac of Business and Industrial Financial Ratios, Dun & BradstreetsIndustry Norms and Key Business Ratios, Business Month, FTC QuarterlyReports, Robert Morris Associates Statement Studies, Value Line, and industrysources.5 A sample from one available source of industry averages is given inTable 2.5.Many people mistakenly believe that as long as the firm being analyzed has avalue better than the industry average, it can be viewed favorably. However,this better than average viewpoint can be misleading. Quite often a ratio valuethat is far better than the norm can indicate problems that, on more carefulanalysis, may be more severe than had the ratio been worse than the industryaverage. It is therefore important to investigate significant deviations to eitherside of the industry standard.In early 2004, Mary Boyle, the chief financial analyst at Caldwell Manufacturing,a producer of heat exchangers, gathered data on the firms financial performanceduring 2003, the year just ended. She calculated a variety of ratios and obtainedindustry averages. She was especially interested in inventory turnover, whichreflects the speed with which the firm moves its inventory from raw materialsthrough production into finished goods and to the customer as a completed sale.Generally, higher values of this ratio are preferred, because they indicate aquicker turnover of inventory. Caldwell Manufacturings calculated inventoryturnover for 2003 and the industry average inventory turnover were as follows:Inventory turnover, 2003Caldwell ManufacturingIndustry average14.89.75. Cross-sectional comparisons of firms operating in several lines of business are difficult to perform. The use ofweighted-average industry average ratios based on the firms product-line mix or, if data are available, analysis ofthe firm on a product-line basis can be performed to evaluate a multiproduct firm.CHAPTER 2TABLE 2.5Line of business(number ofconcernsreporting)b51Financial Statements and AnalysisIndustry Average Ratios (2001) for Selected Lines of BusinessaTotalliabilitiesto networth(%)Currentratio(X)Quickratio(X)Sales toinventory(X)Collectionperiod(days)Totalassetsto sales(%)Returnon totalassets(%)Returnon networth(%)Department6.21.96.02.934.319.7stores3.00.84.78.050.962.04.08.51220.127.116.11(167)220.127.116.114.768.2188.8.131.52.92.0Electronic3.61.819.034.736.4computers1.81.09.155.959.722.214.171.1243.922.214.171.124(91)220.127.116.115.4102.39.8428.4(0.8)(3.1)2.0Grocery2.50.931.01.1stores1.50.419.72.914.418.104.22.1684.320.3188.8.131.52(541)1.00.214.011.15.831.3294.20.31.03.8Motor2.01.0vehicles1.50.711.218.527.9220.127.116.114.18.726.739.0126.96.36.199(38)1.20.315.65.847.559.23188.8.131.52.4Returnon sales(%)aThese values are given for each ratio for each line of business. The center value is the median, and the values immediately above and below it arethe upper and lower quartiles, respectively.bStandard Industrial Classification (SIC) codes for the lines of business shown are, respectively: SIC #5311, SIC #3571, SIC #5411, SIC #3711.Source: Industry Norms and Key Business Ratios, Copyright 2001 Dun & Bradstreet, Inc. Reprinted with permission.Marys initial reaction to these data was that the firm had managed its inventory significantly better than the average firm in the industry. The turnover wasnearly 53% faster than the industry average. Upon reflection, however, she realized that a very high inventory turnover could also mean very low levels of inventory. The consequence of low inventory could be excessive stockouts (insufficientinventory). Discussions with people in the manufacturing and marketing departments did in fact uncover such a problem: Inventories during the year wereextremely low, the result of numerous production delays that hindered the firmsability to meet demand and resulted in lost sales. What had initially appeared toreflect extremely efficient inventory management was actually the symptom of amajor problem.Time-Series Analysistime-series analysisEvaluation of the firms financialperformance over time usingfinancial ratio analysis.Time-series analysis evaluates performance over time. Comparison of current topast performance, using ratios, enables analysts to assess the firms progress.Developing trends can be seen by using multiyear comparisons. As in crosssectional analysis, any significant year-to-year changes may be symptomatic of amajor problem.52PART 1Introduction to Managerial FinanceCombined AnalysisThe most informative approach to ratio analysis combines cross-sectional andtime-series analyses. A combined view makes it possible to assess the trend in thebehavior of the ratio in relation to the trend for the industry. Figure 2.1 depictsthis type of approach using the average collection period ratio of Bartlett Company, over the years 20002003. This ratio reflects the average amount of time ittakes the firm to collect bills, and lower values of this ratio generally are preferred.The figure quickly discloses that (1) Bartletts effectiveness in collecting its receivables is poor in comparison to the industry, and (2) Bartletts trend is towardlonger collection periods. Clearly, Bartlett needs to shorten its collection period.Cautions About Using Ratio AnalysisBefore discussing specific ratios, we should consider the following cautions abouttheir use:FIGURE 2.1Combined AnalysisCombined cross-sectionaland time-series view ofBartlett Companys averagecollection period, 20002003Average Collection Period (days)1. Ratios with large deviations from the norm only indicate symptoms of aproblem. Additional analysis is typically needed to isolate the causes of theproblem. The fundamental point is this: Ratio analysis merely directs attention to potential areas of concern; it does not provide conclusive evidence asto the existence of a problem.2. A single ratio does not generally provide sufficient information from whichto judge the overall performance of the firm. Only when a group of ratios isused can reasonable judgments be made. However, if an analysis is concerned only with certain specific aspects of a firms financial position, one ortwo ratios may be sufficient.3. The ratios being compared should be calculated using financial statementsdated at the same point in time during the year. If they are not, the effects of7060Bartlett50Industry4030200020012002Year2003CHAPTER 2Financial Statements and Analysis53seasonality may produce erroneous conclusions and decisions. For example,comparison of the inventory turnover of a toy manufacturer at the end ofJune with its end-of-December value can be misleading. Clearly, the seasonalimpact of the December holiday selling season would skew any comparisonof the firms inventory management.4. It is preferable to use audited financial statements for ratio analysis. If thestatements have not been audited, the data contained in them may not reflectthe firms true financial condition.5. The financial data being compared should have been developed in the sameway. The use of differing accounting treatmentsespecially relative to inventory and depreciationcan distort the results of ratio analysis, regardless ofwhether cross-sectional or time-series analysis is used.6. Results can be distorted by inflation, which can cause the book values ofinventory and depreciable assets to differ greatly from their true (replacement) values. Additionally, inventory costs and depreciation write-offs candiffer from their true values, thereby distorting profits. Without adjustment,inflation tends to cause older firms (older assets) to appear more efficient andprofitable than newer firms (newer assets). Clearly, in using ratios, care mustbe taken to compare older to newer firms or a firm to itself over a long periodof time.Categories of Financial RatiosFinancial ratios can be divided for convenience into five basic categories: liquidity, activity, debt, profitability, and market ratios. Liquidity, activity, and debtratios primarily measure risk. Profitability ratios measure return. Market ratioscapture both risk and return.As a rule, the inputs necessary to an effective financial analysis include, at aminimum, the income statement and the balance sheet. We will use the 2003 and2002 income statements and balance sheets for Bartlett Company, presented earlier in Tables 2.1 and 2.2, to demonstrate ratio calculations. Note, however, thatthe ratios presented in the remainder of this chapter can be applied to almost anycompany. Of course, many companies in different industries use ratios that focuson aspects peculiar to their industry.Review Questions24252627With regard to financial ratio analysis, how do the viewpoints held by thefirms present and prospective shareholders, creditors, and managementdiffer?What is the difference between cross-sectional and time-series ratio analysis? What is benchmarking?What types of deviations from the norm should the analyst pay primaryattention to when performing cross-sectional ratio analysis? Why?Why is it preferable to compare ratios calculated using financial statements that are dated at the same point in time during the year?54PART 1Introduction to Managerial FinanceLG32.3 Liquidity RatiosliquidityA firms ability to satisfy itsshort-term obligations as theycome due.The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. Liquidity refers to the solvency of the firms overall financial positionthe ease with which it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratiosare viewed as good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio.Current Ratiocurrent ratioA measure of liquidity calculatedby dividing the firms currentassets by its current liabilities.The current ratio, one of the most commonly cited financial ratios, measures thefirms ability to meet its short-term obligations. It is expressed as follows:Current ratioCurrent assetsCurrent liabilitiesThe current ratio for Bartlett Company in 2003 is$1,223,000$620,0001.97Generally, the higher the current ratio, the more liquid the firm is consideredto be. A current ratio of 2.0 is occasionally cited as acceptable, but a valuesacceptability depends on the industry in which the firm operates. For example, acurrent ratio of 1.0 would be considered acceptable for a public utility but mightbe unacceptable for a manufacturing firm. The more predictable a firms cashflows, the lower the acceptable current ratio. Because Bartlett Company is in abusiness with a relatively predictable annual cash flow, its current ratio of 1.97should be quite acceptable.Quick (Acid-Test) Ratioquick (acid-test) ratioA measure of liquidity calculatedby dividing the firms currentassets minus inventory by itscurrent liabilities.The quick (acid-test) ratio is similar to the current ratio except that it excludesinventory, which is generally the least liquid current asset. The generally low liquidity of inventory results from two primary factors: (1) many types of inventorycannot be easily sold because they are partially completed items, special-purposeitems, and the like; and (2) inventory is typically sold on credit, which means thatit becomes an account receivable before being converted into cash. The quickratio is calculated as follows:6Quick ratioCurrent assets InventoryCurrent liabilitiesThe quick ratio for Bartlett Company in 2003 is$1,223,000 $289,000$620,000$934,000$620,0001.516. Sometimes the quick ratio is defined as (cash marketable securities accounts receivable) current liabilities. Ifa firm were to show as current assets items other than cash, marketable securities, accounts receivable, and inventories, its quick ratio might vary, depending on the method of calculation.CHAPTER 2Financial Statements and Analysis55A quick ratio of 1.0 or greater is occasionally recommended, but as with thecurrent ratio, what value is acceptable depends largely on the industry. The quickratio provides a better measure of overall liquidity only when a firms inventorycannot be easily converted into cash. If inventory is liquid, the current ratio is apreferred measure of overall liquidity.Review Question28LG3Under what circumstances would the current ratio be the preferred measure of overall firm liquidity? Under what circumstances would the quickratio be preferred?2.4 Activity Ratiosactivity ratiosMeasure the speed with whichvarious accounts are convertedinto sales or cashinflows oroutflows.Activity ratios measure the speed with which various accounts are converted intosales or cashinflows or outflows. With regard to current accounts, measures ofliquidity are generally inadequate because differences in the composition of afirms current assets and current liabilities can significantly affect its true liquidity. It is therefore important to look beyond measures of overall liquidity andto assess the activity (liquidity) of specific current accounts. A number of ratiosare available for measuring the activity of the most important current accounts,which include inventory, accounts receivable, and accounts payable.7 The efficiency with which total assets are used can also be assessed.Inventory Turnoverinventory turnoverMeasures the activity, or liquidity, of a firms inventory.Inventory turnover commonly measures the activity, or liquidity, of a firmsinventory. It is calculated as follows:Inventory turnoverCost of goods soldInventoryApplying this relationship to Bartlett Company in 2003 yieldsInventory turnover$2,088,000$289,0007.2The resulting turnover is meaningful only when it is compared with that of otherfirms in the same industry or to the firms past inventory turnover. An inventory7. For convenience, the activity ratios involving these current accounts assume that their end-of-period values aregood approximations of the average account balance during the periodtypically 1 year. Technically, when themonth-end balances of inventory, accounts receivable, or accounts payable vary during the year, the average balance, calculated by summing the 12 month-end account balances and dividing the total by 12, should be usedinstead of the year-end value. If month-end balances are unavailable, the average can be approximated by dividingthe sum of the beginning-of-year and end-of-year balances by 2. These approaches ensure a ratio that on the averagebetter reflects the firms circumstances. Because the data needed to find averages are generally unavailable to theexternal analyst, year-end values are frequently used to calculate activity ratios for current accounts.56PART 1Introduction to Managerial Financeaverage age of inventoryAverage number of days salesin inventory.turnover of 20.0 would not be unusual for a grocery store, whereas a commoninventory turnover for an aircraft manufacturer is 4.0.Inventory turnover can be easily converted into an average age of inventoryby dividing it into 360the assumed number of days in a year.8 For BartlettCompany, the average age of inventory in 2003 is 50.0 days (360 7.2). Thisvalue can also be viewed as the average number of days sales in inventory.Average Collection Periodaverage collection periodThe average amount of timeneeded to collect accountsreceivable.The average collection period, or average age of accounts receivable, is useful inevaluating credit and collection policies.9 It is arrived at by dividing the averagedaily sales10 into the accounts receivable balance:Average collection periodAccounts receivableAverage sales per dayAccounts receivableAnnual sales360The average collection period for Bartlett Company in 2003 is$503,000$3,074,000360$503,000$8,53958.9 daysOn the average, it takes the firm 58.9 days to collect an account receivable.The average collection period is meaningful only in relation to the firmscredit terms. If Bartlett Company extends 30-day credit terms to customers, anaverage collection period of 58.9 days may indicate a poorly managed credit orcollection department, or both. It is also possible that the lengthened collectionperiod resulted from an intentional relaxation of credit-term enforcement inresponse to competitive pressures. If the firm had extended 60-day credit terms,the 58.9-day average collection period would be quite acceptable. Clearly, additional information is needed to evaluate the effectiveness of the firms credit andcollection policies.Average Payment Periodaverage payment periodThe average amount of timeneeded to pay accounts payable.The average payment period, or average age of accounts payable, is calculated inthe same manner as the average collection period:Average payment periodAccounts payableAverage purchases per day8. Unless otherwise specified, a 360-day year consisting of twelve 30-day months is assumed throughout this textbook. This assumption simplifies the calculations used to illustrate key concepts.9. The average collection period is sometimes called the days sales outstanding (DSO). A discussion of the evaluation and establishment of credit and collection policies is presented in Chapter 14.10. The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If this is not the case,average credit sales per day should be substituted for average sales per day.CHAPTER 2Financial Statements and Analysis57Accounts payableAnnual purchases360The difficulty in calculating this ratio stems from the need to find annual purchases,11 a value not available in published financial statements. Ordinarily, purchases are estimated as a given percentage of cost of goods sold. If we assumethat Bartlett Companys purchases equaled 70 percent of its cost of goods sold in2003, its average payment period is$382,0000.70 $2,088,000360$382,000$4,06094.1 daysThis figure is meaningful only in relation to the average credit terms extended tothe firm. If Bartlett Companys suppliers have extended, on average, 30-daycredit terms, an analyst would give Bartlett a low credit rating. Prospectivelenders and suppliers of trade credit are most interested in the average paymentperiod because it provides insight into the firms bill-paying patterns.Total Asset Turnovertotal asset turnoverIndicates the efficiency withwhich the firm uses its assets togenerate sales.The total asset turnover indicates the efficiency with which the firm uses its assetsto generate sales. Total asset turnover is calculated as follows:Total asset turnoverSalesTotal assetsThe value of Bartlett Companys total asset turnover in 2003 is$3,074,000$3,597,000HintThe higher the cost ofthe new assets, the larger thedenominator and thus thesmaller the ratio. Therefore,because of inflation and the useof historical costs, firms withnewer assets will tend to havelower turnovers than those witholder assets.0.85This means the company turns over its assets 0.85 times a year.Generally, the higher a firms total asset turnover, the more efficiently itsassets have been used. This measure is probably of greatest interest to management, because it indicates whether the firms operations have been financiallyefficient.Review Question29To assess the firms average collection period and average payment periodratios, what additional information is needed, and why?11. Technically, annual credit purchasesrather than annual purchasesshould be used in calculating this ratio.For simplicity, this refinement is ignored here.58PART 1Introduction to Managerial FinanceLG42.5 Debt Ratiosfinancial leverageThe magnification of risk andreturn introduced through the useof fixed-cost financing, such asdebt and preferred stock.EXAMPLEdegree of indebtednessMeasures the amount of debtrelative to other significantbalance sheet amounts.ability to service debtsThe ability of a firm to makethe payments required on ascheduled basis over the lifeof a debt.coverage ratiosRatios that measure the firmsability to pay certain fixedcharges.The debt position of a firm indicates the amount of other peoples money beingused to generate profits. In general, the financial analyst is most concerned withlong-term debts, because these commit the firm to a stream of payments over thelong run. Because creditors claims must be satisfied before the earnings can be distributed to shareholders, present and prospective shareholders pay close attentionto the firms ability to repay debts. Lenders are also concerned about the firmsindebtedness. Management obviously must be concerned with indebtedness.In general, the more debt a firm uses in relation to its total assets, the greaterits financial leverage. Financial leverage is the magnification of risk and returnintroduced through the use of fixed-cost financing, such as debt and preferredstock. The more fixed-cost debt a firm uses, the greater will be its expected riskand return.Patty Akers is in the process of incorporating her new business. After muchanalysis she determined that an initial investment of $50,000$20,000 in current assets and $30,000 in fixed assetsis necessary. These funds can beobtained in either of two ways. The first is the no-debt plan, under which shewould invest the full $50,000 without borrowing. The other alternative, the debtplan, involves investing $25,000 and borrowing the balance of $25,000 at 12%annual interest.Regardless of which alternative she chooses, Patty expects sales to average$30,000, costs and operating expenses to average $18,000, and earnings to betaxed at a 40% rate. Projected balance sheets and income statements associatedwith the two plans are summarized in Table 2.6. The no-debt plan results inafter-tax profits of $7,200, which represent a 14.4% rate of return on Pattys$50,000 investment. The debt plan results in $5,400 of after-tax profits, whichrepresent a 21.6% rate of return on Pattys investment of $25,000. The debt planprovides Patty with a higher rate of return, but the risk of this plan is also greater,because the annual $3,000 of interest must be paid before receipt of earnings.The example demonstrates that with increased debt comes greater risk aswell as higher potential return. Therefore, the greater the financial leverage, thegreater the potential risk and return. A detailed discussion of the impact of debton the firms risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial debt ratios to assess externally a firms debt position.There are two general types of debt measures: measures of the degree ofindebtedness and measures of the ability to service debts. The degree of indebtedness measures the amount of debt relative to other significant balance sheetamounts. A popular measure of the degree of indebtedness is the debt ratio.The second type of debt measure, the ability to service debts, reflects a firmsability to make the payments required on a scheduled basis over the life of adebt.12 The firms ability to pay certain fixed charges is measured using coverageratios. Typically, higher coverage ratios are preferred, but too high a ratio (above12. The term service refers to the payment of interest and repayment of principal associated with a firms debt obligations. When a firm services its debts, it paysor fulfillsthese obligations.CHAPTER 2TABLE 2.6Financial Statements and Analysis59Financial Statements Associated withPattys AlternativesNo-debt planDebt plan$20,000$20,000Balance SheetsCurrent assetsFixed assets30,000(1) Equity$50,000$Debt (12% interest)30,000$50,000Total assets$25,000050,00025,000$50,000$50,000$30,000Total liabilities and equity$30,000Income StatementsSalesLess: Costs and operatingexpensesLess: Interest expense18,00018,000$12,000Operating profits$12,0000Net profit before taxes0.12$25,000 =$12,0003,000$ 9,000Less: Taxes (rate = 40%)4,8003,600(2) Net profit after taxes$ 7,200$ 5,400Return on equity [(2)$7,200$50,000(1)]14.4%$5,400$25,00021.6%industry norms) may result in unnecessarily low risk and return. In general, thelower the firms coverage ratios, the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances would force a firm into bankruptcy.Two popular coverage ratios are the times interest earned ratio and the fixedpayment coverage ratio.13Debt Ratiodebt ratioMeasures the proportion of totalassets financed by the firmscreditors.The debt ratio measures the proportion of total assets financed by the firms creditors. The higher this ratio, the greater the amount of other peoples money beingused to generate profits. The ratio is calculated as follows:Debt ratioTotal liabilitiesTotal assets13. Coverage ratios use data that are derived on an accrual basis (discussed in Chapter 1) to measure what in a strictsense should be measured on a cash basis. This occurs because debts are serviced by using cash flows, not theaccounting values shown on the firms financial statements. But because it is difficult to determine cash flows available for debt service from the firms financial statements, the calculation of coverage ratios as presented here is quitecommon thanks to the ready availability of financial statement data.60PART 1Introduction to Managerial FinanceThe debt ratio for Bartlett Company in 2003 is$1,643,000$3,597,0000.45745.7%This value indicates that the company has financed close to half of its assets withdebt. The higher this ratio, the greater the firms degree of indebtedness and themore financial leverage it has.Times Interest Earned Ratiotimes interest earned ratioMeasures the firms ability tomake contractual interestpayments; sometimes called theinterest coverage ratio.The times interest earned ratio, sometimes called the interest coverage ratio, measures the firms ability to make contractual interest payments. The higher itsvalue, the better able the firm is to fulfill its interest obligations. The times interest earned ratio is calculated as follows:Times interest earned ratioEarnings before interest and taxesInterestThe figure for earnings before interest and taxes is the same as that for operatingprofits shown in the income statement. Applying this ratio to Bartlett Companyyields the following 2003 value:Times interest earned ratio$418,000$93,0004.5The times interest earned ratio for Bartlett Company seems acceptable. A valueof at least 3.0and preferably closer to 5.0is often suggested. The firmsearnings before interest and taxes could shrink by as much as 78 percent[(4.5 1.0) 4.5], and the firm would still be able to pay the $93,000 in interestit owes. Thus it has a good margin of safety.Fixed-Payment Coverage Ratiofixed-payment coverage ratioMeasures the firms ability tomeet all fixed-paymentobligations.The fixed-payment coverage ratio measures the firms ability to meet all fixedpayment obligations, such as loan interest and principal, lease payments, and preferred stock dividends.14 As is true of the times interest earned ratio, the higherthis value, the better. The formula for the fixed-payment coverage ratio isFixedpaymentcoverageratioEarnings before interest and taxes Lease paymentsInterest Lease payments{(Principal payments Preferred stock dividends) [1/(1 T )]}where T is the corporate tax rate applicable to the firms income. The term1/(1 T) is included to adjust the after-tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-14. Although preferred stock dividends, which are stated at the time of issue, can be passed (not paid) at theoption of the firms directors, it is generally believed that the payment of such dividends is necessary. This text therefore treats the preferred stock dividend as a contractual obligation, to be paid as a fixed amount, as scheduled.CHAPTER 2Financial Statements and Analysis61tax values of all other terms. Applying the formula to Bartlett Companys 2003data yieldsFixed-paymentcoverage ratio$93,000$35,000$453,000$242,000$418,000 $35,000{($71,000 $10,000)[1/(10.29)]}1.9Because the earnings available are nearly twice as large as its fixed-paymentobligations, the firm appears safely able to meet the latter.Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the ratio, the greater the risk to both lenders and owners;the greater the ratio, the lower the risk. This ratio allows interested parties toassess the firms ability to meet additional fixed-payment obligations withoutbeing driven into bankruptcy.Review Questions210 What is financial leverage?211 What ratio measures the firms degree of indebtedness? What ratios assessthe firms ability to service debts?LG52.6 Profitability RatiosThere are many measures of profitability. As a group, these measures enable theanalyst to evaluate the firms profits with respect to a given level of sales, a certain level of assets, or the owners investment. Without profits, a firm could notattract outside capital. Owners, creditors, and management pay close attention toboosting profits because of the great importance placed on earnings in themarketplace.Common-Size Income Statementscommon-size income statementAn income statement in whicheach item is expressed as apercentage of sales.A popular tool for evaluating profitability in relation to sales is the common-sizeincome statement.15 Each item on this statement is expressed as a percentage ofsales. Common-size income statements are especially useful in comparing performance across years. Three frequently cited ratios of profitability that can be readdirectly from the common-size income statement are (1) the gross profit margin,(2) the operating profit margin, and (3) the net profit margin.Common-size income statements for 2003 and 2002 for Bartlett Companyare presented and evaluated in Table 2.7. These statements reveal that the firms15. This statement is sometimes called a percent income statement. The same treatment is often applied to the firmsbalance sheet to make it easier to evaluate changes in the asset and financial structures of the firm. In addition tomeasuring profitability, these statements in effect can be used as an alternative or supplement to liquidity, activity,and debt-ratio analysis.62PART 1Introduction to Managerial FinanceTABLE 2.7Bartlett Company Common-Size IncomeStatementsFor the years endedDecember 31Evaluationa2003200220022003100.0%100.0%same67.966.7worse32.1%33.3%worseSelling expense3.3%4.2%betterGeneral and administrative expenses6.86.7betterLease expense1.11.3betterDepreciation expense7.39.3better18.5%21.5%better13.6%11.8%better3.03.5better8.3%betterSales revenueLess: Cost of goods sold(1) Gross profit marginLess: Operating expensesTotal operating expense(2) Operating profit marginLess: Interest expenseNet profits before taxes10.6%Less: Taxes3.12.5worsebNet profits after taxes7.5%5.8%betterLess: Preferred stock dividends0.30.4better7.2%5.4%better(3) Net profit marginaSubjectiveassessments based on data provided.as a percent of sales increased noticeably between 2002 and 2003 because of differing costs andexpenses, whereas the average tax rates (taxes net profits before taxes) for 2002 and 2003 remainedabout the same30% and 29%, respectively.bTaxescost of goods sold increased from 66.7 percent of sales in 2002 to 67.9 percent in2003, resulting in a worsening gross profit margin. However, thanks to adecrease in total operating expenses, the firms net profit margin rose from 5.4percent of sales in 2002 to 7.2 percent in 2003. The decrease in expenses morethan compensated for the increase in the cost of goods sold. A decrease in thefirms 2003 interest expense (3.0 percent of sales versus 3.5 percent in 2002)added to the increase in 2003 profits.Gross Profit Margingross profit marginMeasures the percentage of eachsales dollar remaining after thefirm has paid for its goods.The gross profit margin measures the percentage of each sales dollar remainingafter the firm has paid for its goods. The higher the gross profit margin, the better(that is, the lower the relative cost of merchandise sold). The gross profit marginis calculated as follows:Gross profit marginSalesCost of goods soldSalesGross profitsSalesCHAPTER 2FOCUS ON e-FINANCEmargin, when sales numbers weredown, the ShopKos gross profitmargin also suffered.Software from SpotlightSolutions, a Cincinnati company,applied information technology toShopKos decisions about markdowns. Company research indicated that multiple markdowns arenot so profitable as properly timedsingle markdowns. It developed aprogram (Markdown Optimizer) toautomate optimal price change actions so that retailers can achievehigher sales and margins from existing merchandise inventories.The program analyzes severalyears of sales figures on similarproducts and develops a demandpattern, taking into account thesensitivity of customer demand toprice changes (price elasticity).The software is dynamicthat is,it learns retail customers preferences and incorporates that information into its models.63In PracticeShopKos Software SolutionSpecialized financial analysis toolscan help companies achieve significant improvements in ratiomeasures of performance. Withassistance from sophisticated newsoftware programs, for example,companies can convert masses ofhistorical sales data into usefulinformation that guides pricingstrategy and improves operatingefficiency.Like many of its rivals,ShopKo Stores, a Fortune 500 discount chain based in Green Bay,Wisconsin, had no underlyingstrategy to sell slow-movingitems. It used guesstimates toreduce prices a bit at a time, untileventually the merchandise sold.However, total sales suffered fromthe companys having no way todetermine the maximum price atwhich goods would sell. Becausethe dollar volume of sales entersinto both the numerator and thedenominator in the gross profitHint This is a verysignificant ratio for smallretailers, especially during timesof inflationary prices. If theowner of the firm does not raiseprices when the cost of sales isrising, the gross profit marginwill erode.Financial Statements and AnalysisDuring a six-month pilot project, ShopKo provided three yearsof sales data on 300 apparel, home,and other products. MarkdownOptimizer ran through a series ofmathematical models to arrive atoptimal timing for and amount ofprice cuts. ShopKo tracked andcompared sales for these clearance items using the recommended markdowns. Sales onthose products were 14 percenthigher than the prior year. Thecompanys gross profit marginrose 24 percent, despite flat samestore sales in one quarter. ShopKonow uses Markdown Optimizer forall products.Sources: Amy Merrick, Retailers Try to GetLeg Up on Markdowns with New Software,Wall Street Journal (August 7, 2001), pp. A1,A6; ShopKo Uses Spotlight SolutionsPrice Optimization Software, downloadedfrom Spotlight Solutions Web site, www.spotlightsolutions.com/cshopko.html,November 6, 2001.Bartlett Companys gross profit margin for 2003 is$3,074,000 $2,088,000$3,074,000$986,000$3,074,00032.1%This value is labeled (1) on the common-size income statement in Table 2.7.Operating Profit Marginoperating profit marginMeasures the percentage of eachsales dollar remaining after allcosts and expenses other thaninterest, taxes, and preferredstock dividends are deducted;the pure profits earned on eachsales dollar.The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the pure profits earned on each sales dollar.Operating profits are pure because they measure only the profits earned onoperations and ignore interest, taxes, and preferred stock dividends. A high operating profit margin is preferred. The operating profit margin is calculated asfollows:Operating profit marginOperating profitsSales64PART 1Introduction to Managerial FinanceBartlett Companys operating profit margin for 2003 is$418,000$3,074,00013.6%This value is labeled (2) on the common-size income statement in Table 2.7.Net Profit Marginnet profit marginMeasures the percentage of eachsales dollar remaining after allcosts and expenses, includinginterest, taxes, and preferredstock dividends, have beendeducted.The net profit margin measures the percentage of each sales dollar remainingafter all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firms net profit margin, the better.The net profit margin is calculated as follows:Net profit marginEarnings available for common stockholdersSalesBartlett Companys net profit margin for 2003 is$221,000$3,074,0007.2%This value is labeled (3) on the common-size income statement in Table 2.7.The net profit margin is a commonly cited measure of the firms success withrespect to earnings on sales. Good net profit margins differ considerably acrossindustries. A net profit margin of 1 percent or less would not be unusual for agrocery store, whereas a net profit margin of 10 percent would be low for a retailjewelry store.Earnings per Share (EPS)Hint EPS represents thedollar amount earned on behalfof each sharenot the amountof earnings actually distributedto shareholders.The firms earnings per share (EPS) is generally of interest to present or prospective stockholders and management. As we noted earlier, EPS represents the number of dollars earned during the period on behalf of each outstanding share ofcommon stock. Earnings per share is calculated as follows:Earnings per shareEarnings available for common stockholdersNumber of shares of common stock outstandingBartlett Companys earnings per share in 2003 is$221,00076,262$2.90This figure represents the dollar amount earned on behalf of each share. The dollar amount of cash actually distributed to each shareholder is the dividend pershare (DPS), which, as noted in Bartlett Companys income statement (Table2.1), rose to $1.29 in 2003 from $0.75 in 2002. EPS is closely watched by theinvesting public and is considered an important indicator of corporate success.CHAPTER 2Financial Statements and Analysis65Return on Total Assets (ROA)return on total assets (ROA)Measures the overall effectiveness of management in generating profits with its availableassets; also called the return oninvestment (ROI).The return on total assets (ROA), often called the return on investment (ROI),measures the overall effectiveness of management in generating profits with itsavailable assets. The higher the firms return on total assets, the better. The returnon total assets is calculated as follows:Return on total assetsEarnings available for common stockholdersTotal assetsBartlett Companys return on total assets in 2003 is$221,000$3,597,0006.1%This value indicates that the firm earned 6.1 cents on each dollar of assetinvestment.Return on Common Equity (ROE)return on common equity (ROE)Measures the return earned onthe common stockholdersinvestment in the firm.The return on common equity (ROE) measures the return earned on the commonstockholders investment in the firm. Generally, the higher this return, the betteroff are the owners. Return on common equity is calculated as follows:Return on common equityEarnings available for common stockholdersCommon stock equityThis ratio for Bartlett Company in 2003 is$221,000$1,754,00012.6%Note that the value for common stock equity ($1,754,000) was found by subtracting the $200,000 of preferred stock equity from the total stockholdersequity of $1,954,000 (see Bartlett Companys 2003 balance sheet in Table 2.2).The calculated ROE of 12.6 percent indicates that during 2003 Bartlett earned12.6 cents on each dollar of common stock equity.Review Questions212 What three ratios of profitability are found on a common-size incomestatement?213 What would explain a firms having a high gross profit margin and a lownet profit margin?214 Which measure of profitability is probably of greatest interest to theinvesting public? Why?66PART 1Introduction to Managerial FinanceLG52.7 Market Ratiosmarket ratiosRelate a firms market value, asmeasured by its current shareprice, to certain accountingvalues.Market ratios relate the firms market value, as measured by its current shareprice, to certain accounting values. These ratios give insight into how wellinvestors in the marketplace feel the firm is doing in terms of risk and return.They tend to reflect, on a relative basis, the common stockholders assessment ofall aspects of the firms past and expected future performance. Here we considertwo popular market ratios, one that focuses on earnings and another that considers book value.Price/Earnings (P/E) Ratioprice/earnings (P/E) ratioMeasures the amount thatinvestors are willing to pay foreach dollar of a firms earnings;the higher the P/E ratio, thegreater is investor confidence.The price/earnings (P/E) ratio is commonly used to assess the owners appraisalof share value.16 The P/E ratio measures the amount that investors are willing topay for each dollar of a firms earnings. The level of the price/earnings ratio indicates the degree of confidence that investors have in the firms future performance. The higher the P/E ratio, the greater is investor confidence. The P/E ratiois calculated as follows:Price/earnings (P/E) ratioMarket price per share of common stockEarnings per shareIf Bartlett Companys common stock at the end of 2003 was selling at $32.25,using the EPS of $2.90, the P/E ratio at year-end 2003 is$32.25$2.9011.1This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The P/E ratio is most informative when applied in cross-sectional analysisusing an industry average P/E ratio or the P/E ratio of a benchmark firm.Market/Book (M/B) Ratiomarket/book (M/B) ratioProvides an assessment of howinvestors view the firms performance. Firms expected to earnhigh returns relative to their risktypically sell at higher M/Bmultiples.The market/book (M/B) ratio provides an assessment of how investors view thefirms performance. It relates the market value of the firms shares to theirbookstrict accountingvalue. To calculate the firms M/B ratio, we first needto find the book value per share of common stock:Book value pershare of common stockCommon stock equityNumber of shares of common stock outstandingSubstituting the appropriate values for Bartlett Company from its 2003 balancesheet, we getBook value per share of common stock$1,754,00076,262$23.0016. Use of the price/earnings ratio to estimate the value of the firm is part of the discussion of Other approaches tocommon stock valuation in Chapter 7.CHAPTER 2Financial Statements and Analysis67The formula for the market/book ratio isMarket/book (M/B) ratioMarket price per share of common stockBook value per share of common stockSubstituting Bartlett Companys end of 2003 common stock price of $32.25 andits $23.00 book value per share of common stock (calculated above) into the M/Bratio formula, we getMarket/book (M/B) ratio$32.25$23.001.40This M/B ratio means that investors are currently paying $1.40 for each $1.00 ofbook value of Bartlett Companys stock.The stocks of firms that are expected to perform wellimprove profits,increase their market share, or launch successful productstypically sell athigher M/B ratios than the stocks of firms with less attractive outlooks. Simplystated, firms expected to earn high returns relative to their risk typically sell athigher M/B multiples. Clearly, Bartletts future prospects are being viewed favorably by investors, who are willing to pay more than its book value for the firmsshares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally, to get afeel for the firms risk and return compared to peer firms.Review Question215 How do the price/earnings (P/E) ratio and the market/book (M/B) ratioprovide a feel for the firms risk and return?LG62.8 A Complete Ratio AnalysisAnalysts frequently wish to take an overall look at the firms financial performance and status. Here we consider two popular approaches to a complete ratioanalysis: (1) summarizing all ratios and (2) the DuPont system of analysis. Thesummary analysis approach tends to view all aspects of the firms financial activities to isolate key areas of responsibility. The DuPont system acts as a searchtechnique aimed at finding the key areas responsible for the firms financialcondition.Summarizing All RatiosWe can use Bartlett Companys ratios to perform a complete ratio analysis usingboth cross-sectional and time-series analysis approaches. The 2003 ratio valuescalculated earlier and the ratio values calculated for 2001 and 2002 for BartlettCompany, along with the industry average ratios for 2003, are summarized inTable 2.8, which also shows the formula used to calculate each ratio. Using thesedata, we can discuss the five key aspects of Bartletts performanceliquidity,activity, debt, profitability, and market.68Earnings before interest and taxesInterest1.5goodTimes interest earned ratio1.9OK126.96.36.199good2.082002bOK3.344.3%0.9481.2 days4.545.7%0.7994.1 days51.2 days7.21.461.972003b4.340.0%0.8566.5 days58.9 days6.61.512.05Industryaverage2003cgoodOK0.75poor44.3 daysgood1.43OKCrosssectional2003Earnings before interest and taxes Lease paymentsFixed-payment coverage ratioInt. Lease pay. {(Prin. Pref. div.) [1/(1 T )]}good5.636.8%SalesTotal assets75.8 daysAccounts receivable43.9 daysAverage sales per dayTotal asset turnoverTotal liabilitiesTotal assetsAccounts payableAverage purchases per dayDebt ratioDebtAverage payment periodpoor2.042001aCurrent assets InventoryCurrent liabilitiesAverage collection periodQuick (acid-test) ratioCost of goods soldInventoryCurrent assetsCurrent liabilitiesFormulaYearSummary of Bartlett Company Ratios (20012003, Including 2003 Industry Averages)Inventory turnoverActivityCurrent ratioLiquidityRatioTABLE 2.82.4OKOKOKpoorpoorgoodOKOKTimeseries20012003Evaluationd1.4OKOKOKpoorpoorgoodgoodOKOverall69Operating profit marginGross profitsSalesFormulaEarnings available for common stockholdersTotal assetsOKReturn on total assets(ROA)Return on common equity(ROE)goodgoodMarket price per share of common stockEarnings per share$2.26good$2.90OKbCalculatedfrom data not included in the chapter.by using the financial statements presented in Tables 2.1 and 126.96.36.199OKaCalculated1.30OKPrice/earnings (P/E) ratioMarketEarnings available for common stockholdersSalesNet profit margin5.4%14.6%33.3%2002b7.2%11.8%32.1%2003b6.2%13.6%30.0%Industryaverage2003cgood11.0%OKCrosssectional2003OKgoodOKTimeseries200120034.2%6.1%10.0e11.112.513.7%4.6%OK8.5%goodMarket price per share of common stockMarket/book (M/B) ratioBook value per share of common stockOK10.5Earnings available for common stockholdersCommon stock equity7.8%1.25OK12.6%OKEarnings available for common stockholdersEarnings per share (EPS)$3.26Number of shares of common stock outstandinggood8.2%good31.4%2001aOperating profitsSalesGross profit marginProfitabilityRatioYearEvaluationd0.85eOK8.5%good$1.81goodOKOKOverall70PART 1Introduction to Managerial FinanceLiquidityThe overall liquidity of the firm seems to exhibit a reasonably stable trend, having been maintained at a level that is relatively consistent with the industry average in 2003. The firms liquidity seems to be good.ActivityBartlett Companys inventory appears to be in good shape. Its inventory management seems to have improved, and in 2003 it performed at a level above that ofthe industry. The firm may be experiencing some problems with accounts receivable. The average collection period seems to have crept up above that of theindustry. Bartlett also appears to be slow in paying its bills; it pays nearly 30 daysslower than the industry average. This could adversely affect the firms creditstanding. Although overall liquidity appears to be good, the management ofreceivables and payables should be examined. Bartletts total asset turnoverreflects a decline in the efficiency of total asset utilization between 2001 and2002. Although in 2003 it rose to a level considerably above the industry average, it appears that the pre-2002 level of efficiency has not yet been achieved.DebtBartlett Companys indebtedness increased over the 20012003 period and iscurrently above the industry average. Although this increase in the debt ratiocould be cause for alarm, the firms ability to meet interest and fixed-paymentobligations improved, from 2002 to 2003, to a level that outperforms the industry. The firms increased indebtedness in 2002 apparently caused a deteriorationin its ability to pay debt adequately. However, Bartlett has evidently improved itsincome in 2003 so that it is able to meet its interest and fixed-payment obligations at a level consistent with the average in the industry. In summary, it appearsthat although 2002 was an off year, the companys ability to pay debts in 2003compensates for its increased degree of indebtedness.ProfitabilityBartletts profitability relative to sales in 2003 was better than the average company in the industry, although it did not match the firms 2001 performance.Although the gross profit margin was better in 2002 and 2003 than in 2001,higher levels of operating and interest expenses in 2002 and 2003 appear to havecaused the 2003 net profit margin to fall below that of 2001. However, BartlettCompanys 2003 net profit margin is quite favorable when compared to theindustry average.The firms earnings per share, return on total assets, and return on commonequity behaved much as its net profit margin did over the 20012003 period.Bartlett appears to have experienced either a sizable drop in sales between 2001and 2002 or a rapid expansion in assets during that period. The exceptionallyhigh 2003 level of return on common equity suggests that the firm is performingquite well. The firms above-average returnsnet profit margin, EPS, ROA, andROEmay be attributable to the fact that it is more risky than average. A look atmarket ratios is helpful in assessing risk.CHAPTER 2Financial Statements and Analysis71MarketInvestors have greater confidence in the firm in 2003 than in the prior two years,as reflected in the price/earnings (P/E) ratio of 11.1. However, this ratio is belowthe industry average. The P/E ratio suggests that the firms risk has declined butremains above that of the average firm in its industry. The firms market/book(M/B) ratio has increased over the 20012003 period, and in 2003 it exceeds theindustry average. This implies that investors are optimistic about the firms futureperformance. The P/E and M/B ratios reflect the firms increased profitabilityover the 20012003 period: Investors expect to earn high future returns as compensation for the firms above-average risk.In summary, the firm appears to be growing and has recently undergone anexpansion in assets, financed primarily through the use of debt. The 20022003period seems to reflect a phase of adjustment and recovery from the rapid growthin assets. Bartletts sales, profits, and other performance factors seem to be growing with the increase in the size of the operation. In addition, the market responseto these accomplishments appears to have been positive. In short, the firm seemsto have done well in 2003.DuPont System of AnalysisDuPont system of analysisSystem used to dissect the firmsfinancial statements and toassess its financial condition.DuPont formulaMultiplies the firms net profitmargin by its total asset turnoverto calculate the firms return ontotal assets (ROA).The DuPont system of analysis is used to dissect the firms financial statementsand to assess its financial condition. It merges the income statement and balancesheet into two summary measures of profitability: return on total assets (ROA)and return on common equity (ROE). Figure 2.2 depicts the basic DuPont systemwith Bartlett Companys 2003 monetary and ratio values. The upper portion ofthe chart summarizes the income statement activities; the lower portion summarizes the balance sheet activities.The DuPont system first brings together the net profit margin, which measuresthe firms profitability on sales, with its total asset turnover, which indicates howefficiently the firm has used its assets to generate sales. In the DuPont formula, theproduct of these two ratios results in the return on total assets (ROA):ROANet profit marginTotal asset turnoverSubstituting the appropriate formulas into the equation and simplifying results inthe formula given earlier,ROAEarnings available forcommon stockholdersSalesSalesTotal assetsEarnings available forcommon stockholdersTotal assetsWhen the 2003 values of the net profit margin and total asset turnover forBartlett Company, calculated earlier, are substituted into the DuPont formula, theresult isROA7.2%0.856.1%This value is the same as that calculated directly in an earlier section (page 65).The DuPont formula enables the firm to break down its return into profit-onsales and efficiency-of-asset-use components. Typically, a firm with a low netprofit margin has a high total asset turnover, which results in a reasonably goodreturn on total assets. Often, the opposite situation exists.PART 1Introduction to Managerial FinanceFIGURE 2.2DuPont System of AnalysisThe DuPont system of analysis with application to Bartlett Company (2003)Sales$3,074,000minusIncomeStatementCost ofGoods Sold$2,088,000minusOperatingExpenses$568,000minusEarningsAvailablefor CommonStockholders$221,000divided byNet ProfitMargin7.2%Sales$3,074,000InterestExpense$93,000minusTaxes$94,000multipliedbyminusReturn onTotal Assets(ROA)6.1%Preferred StockDividends$10,000Sales$3,074,000CurrentAssets$1,223,000divided byplusBalanceSheet72Total AssetTurnover0.85Total Assets$3,597,000multipliedbyNet FixedAssets$2,374,000CurrentLiabilities$620,000plusLong-TermDebt$1,023,000TotalLiabilities$1,643,000plusStockholdersEquity$1,954,000Total Liabilitiesand StockholdersEquity = TotalAssets$3,597,000divided byCommon StockEquity$1,754,000FinancialLeverageMultiplier (FLM)2.06Return onCommonEquity (ROE)12.6%CHAPTER 2modified DuPont formulaRelates the firms return on totalassets (ROA) to its return oncommon equity (ROE) using thefinancial leverage multiplier(FLM).financial leverage multiplier(FLM)The ratio of the firms total assetsto its common stock equity.Financial Statements and Analysis73The second step in the DuPont system employs the modified DuPont formula.This formula relates the firms return on total assets (ROA) to its return on common equity (ROE). The latter is calculated by multiplying the return on totalassets (ROA) by the financial leverage multiplier (FLM), which is the ratio oftotal assets to common stock equity:ROEROAFLMSubstituting the appropriate formulas into the equation and simplifying results inthe formula given earlier,ROEEarnings available forcommon stockholdersTotal assetsTotal assetsCommon stockequityEarnings available forcommon stockholdersCommon stockequityUse of the financial leverage multiplier (FLM) to convert the ROA into theROE reflects the impact of financial leverage on owners return. Substituting thevalues for Bartlett Companys ROA of 6.1 percent, calculated earlier, andBartletts FLM of 2.06 ($3,597,000 total assets $1,754,000 common stockequity) into the modified DuPont formula yieldsROE6.1%2.0612.6%The 12.6 percent ROE calculated by using the modified DuPont formula is thesame as that calculated directly (page 65).The advantage of the DuPont system is that it allows the firm to break its returnon equity into a profit-on-sales component (net profit margin), an efficiency-ofasset-use component (total asset turnover), and a use-of-financial-leverage component (financial leverage multiplier). The total return to owners therefore can beanalyzed in these important dimensions.The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure 2.2. Beginning with the rightmost valuethe ROEthefinancial analyst moves to the left, dissecting and analyzing the inputs to the formula in order to isolate the probable cause of the resulting above-average (orbelow-average) value. For the sake of discussion, lets assume that Bartletts ROEof 12.6 percent is actually below the industry average. Moving to the left, wewould examine the inputs to the ROEthe ROA and the FLMrelative to theindustry averages. Lets assume that the FLM is in line with the industry average,but the ROA is below the industry average. Moving farther to the left, we examine the two inputs to the ROAthe net profit margin and total asset turnover.Assume that the net profit margin is in line with the industry average, but thetotal asset turnover is below the industry average. Moving still farther to the left,we find that whereas the firms sales are consistent with the industry value,Bartletts total assets have grown significantly during the past year. Looking farther to the left, we would review the firms activity ratios for current assets. Letssay that whereas the firms inventory turnover is in line with the industry average,its average collection period is well above the industry average.Clearly, we can trace the possible problem back to its cause: Bartletts lowROE is primarily the consequence of slow collections of accounts receivable,which resulted in high levels of receivables and therefore high levels of totalassets. The high total assets slowed Bartletts total asset turnover, driving downits ROA, which then drove down its ROE. By using the DuPont system of analysis74PART 1Introduction to Managerial Financeto dissect Bartletts overall returns as measured by its ROE, we found that slowcollections of receivables caused the below-industry-average ROE. Clearly, thefirm needs to manage its credit operations better.Review Questions216 Financial ratio analysis is often divided into five areas: liquidity, activity,debt, profitability, and market ratios. Differentiate each of these areas ofanalysis from the others. Which is of the greatest concern to creditors?217 Describe how you would use a large number of ratios to perform a complete ratio analysis of the firm.218 What three areas of analysis are combined in the modified DuPont formula? Explain how the DuPont system of analysis is used to dissect thefirms results and isolate their causes.S U M M A RYFOCUS ON VALUEFinancial managers review and analyze the firms financial statements periodically, both touncover developing problems and to assess the firms progress toward achieving its goals.These actions are aimed at preserving and creating value for the firms owners. Financialratios enable financial managers to monitor the pulse of the firm and its progress toward itsstrategic goals. Although financial statements and financial ratios rely on accrual concepts,they can provide useful insights into important aspects of risk and return (cash flow) thataffect share price, which management is attempting to maximize.REVIEW OF LEARNING GOALSReview the contents of the stockholders report and the procedures for consolidating international financial statements. The annual stockholders report, which publicly owned corporationsare required to provide to stockholders, documentsthe firms financial activities during the past year.It includes the letter to stockholders and varioussubjective and factual information, as well as fourkey financial statements: the income statement, thebalance sheet, the statement of retained earnings,and the statement of cash flows. Notes describingthe technical aspects of the financial statements follow them. Financial statements of companies thathave operations whose cash flows are denominatedin one or more foreign currencies must be transLG1lated into dollars in accordance with FASBStandard No. 52.Understand who uses financial ratios, and how.Ratio analysis enables present and prospectivestockholders and lenders and the firms management to evaluate the firms financial performance. Itcan be performed on a cross-sectional or a timeseries basis. Benchmarking is a popular type ofcross-sectional analysis. Key cautions for applyingfinancial ratios are: (1) Ratios with large deviationsfrom the norm only indicate symptoms of a problem. (2) A single ratio does not generally providesufficient information. (3) The ratios being compared should be calculated using financial stateLG2CHAPTER 2ments dated at the same point in time during theyear. (4) Audited financial statements should beused. (5) Data should be checked for consistency ofaccounting treatment. (6) Inflation and different asset ages can distort ratio comparisons.Use ratios to analyze a firms liquidity and activity. Liquidity, or ability of the firm to payits bills as they come due, can be measured by thecurrent ratio and the quick (acid-test) ratio. Activity ratios measure the speed with which accountsare converted into sales or cashinflows or outflows. The activity of inventory can be measuredby its turnover, that of accounts receivable by theaverage collection period, and that of accountspayable by the average payment period. Total assetturnover measures the efficiency with which thefirm uses its assets to generate sales. Formulas forthese liquidity and activity ratios are summarizedin Table 2.8.LG3Discuss the relationship between debt and financial leverage and the ratios used to analyzea firms debt. The more debt a firm uses, the greaterits financial leverage, which magnifies both risk andreturn. Financial debt ratios measure both the degree of indebtedness and the ability to service debts.A common measure of indebtedness is the debt ratio. The ability to pay fixed charges can be measured by times interest earned and fixed-paymentLG4SELF-TEST PROBLEMSLG3LG4LG5ST 21Financial Statements and Analysis75coverage ratios. Formulas for these debt ratios aresummarized in Table 2.8.Use ratios to analyze a firms profitability andits market value. The common-size incomestatement, which shows all items as a percentage ofsales, can be used to determine gross profit margin,operating profit margin, and net profit margin.Other measures of profitability include earnings pershare, return on total assets, and return on commonequity. Market ratios include the price/earnings ratio and the market/book ratio. Formulas for theseprofitability and market ratios are summarized inTable 2.8.LG5Use a summary of financial ratios and theDuPont system of analysis to perform a complete ratio analysis. A summary of all ratiosliquidity, activity, debt, profitability, and marketasshown in Table 2.8 can be used to perform a complete ratio analysis using cross-sectional and timeseries analysis approaches. The DuPont system ofanalysis, summarized in Figure 2.2, is a diagnostictool used to find the key areas responsible for thefirms financial performance. It enables the firm tobreak the return on common equity into three components: profit on sales, efficiency of asset use, anduse of leverage. The DuPont system of analysismakes it possible to assess all aspects of the firms activities in order to isolate key areas of responsibility.LG6(Solutions in Appendix B)Ratio formulas and interpretations Without referring to the text, indicate foreach of the following ratios the formula for calculating it and the kinds of problems, if any, the firm is likely to have if that ratio is too high relative to theindustry average. What if the ratio is too low relative to the industry? Create atable similar to the one that follows and fill in the empty blocks.RatioCurrent ratioInventory turnoverTimes interest earnedGross profit marginReturn on total assetsToo highToo low76PART 1LG3LG4LG5Introduction to Managerial FinanceST 22Balance sheet completion using ratios Complete the 2003 balance sheet forOKeefe Industries using the information that follows it.OKeefe IndustriesBalance SheetDecember 31, 2003AssetsLiabilities and Stockholders EquityCashMarketable securitiesAccounts receivableInventoriesTotal current assetsNet fixed assetsTotal assets$30,00025,000$Accounts payableNotes payableAccrualsTotal current liabilitiesLong-term debtStockholders equityTotal liabilities andstockholders equity$120,00020,000$600,000$The following financial data for 2003 are also available:(1) Sales totaled $1,800,000.(6) The current ratio was 1.60.(2) The gross profit margin was 25%.(7) The total asset turnover ratio(3) Inventory turnover was 6.0.was 1.20.(4) There are 360 days in the year.(8) The debt ratio was 60%.(5) The average collection periodwas 40 days.PROBLEMSLG121Reviewing basic financial statements The income statement for the year endedDecember 31, 2003, the balance sheets for December 31, 2003 and 2002, andthe statement of retained earnings for the year ended December 31, 2003, forTechnica, Inc., are given here. Briefly discuss the form and informational contentof each of these statements.Technica, Inc.Income Statementfor the Year Ended December 31, 2003Sales revenueLess: Cost of goods soldGross profitsLess: Operating expensesGeneral and administrative expenseDepreciation expenseTotal operating expenseOperating profitsLess: Interest expenseNet profits before taxesLess: TaxesEarnings available for common stockholdersEarnings per share (EPS)$600,000460,000$140,000$30,00030,00060,000$ 80,00010,000$ 70,00027,100$ 42,900$2.15CHAPTER 2Financial Statements and Analysis77Technica, Inc.Balance SheetsDecember 31Assets20032002Cash$ 15,000$ 16,0007,2008,000Marketable securitiesAccounts receivable34,10042,200Inventories82,00050,000Total current assetsLand and buildings$138,300$116,200$150,000$150,000200,000190,000Machinery and equipmentFurniture and fixtures54,00050,000Other11,00010,000$415,000$400,000Total gross fixed assetsLess: Accumulated depreciation145,000115,000Net fixed assets$270,000$285,000Total assets$408,300$401,200$ 57,000$ 49,00013,00016,0005,0006,000Liabilities and Stockholders EquityAccounts payableNotes payableAccrualsTotal current liabilities$ 75,000$ 71,000$150,000Long-term debt$160,000$110,200$120,000Stockholders equityCommon stock equity (sharesoutstanding: 19,500 in 2003 and20,000 in 2002)Retained earningsTotal stockholders equityTotal liabilities and stockholders equity73,10050,200$183,300$170,200$408,300$401,200Technica, Inc.Statement of Retained Earningsfor the Year Ended December 31, 2003Retained earnings balance (January 1, 2003)Plus: Net profits after taxes (for 2003)$50,20042,900Less: Cash dividends (paid during 2003)Retained earnings balance (December 31, 2003)LG122( 20,000)$73,100Financial statement account identification Mark each of the accounts listed inthe following table as follows:a. In column (1), indicate in which statementincome statement (IS) or balancesheet (BS)the account belongs.78PART 1Introduction to Managerial Financeb. In column (2), indicate whether the account is a current asset (CA), currentliability (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue(R), or stockholders equity (SE).Account name(1)Statement(2)Type of accountAccounts payableAccounts receivableAccrualsAccumulated depreciationAdministrative expenseBuildingsCashCommon stock (at par)Cost of goods soldDepreciationEquipmentGeneral expenseInterest expenseInventoriesLandLong-term debtsMachineryMarketable securitiesNotes payableOperating expensePaid-in capital in excess of parPreferred stockPreferred stock dividendsRetained earningsSales revenueSelling expenseTaxesVehiclesLG123Income statement preparation On December 31, 2003, Cathy Chen, a selfemployed certified public accountant (CPA), completed her first full year in business. During the year, she billed $180,000 for her accounting services. She hadtwo employees: a bookkeeper and a clerical assistant. In addition to her monthlysalary of $4,000, Ms. Chen paid annual salaries of $24,000 and $18,000 to thebookkeeper and the clerical assistant, respectively. Employment taxes and benefitcosts for Ms. Chen and her employees totaled $17,300 for the year. Expenses foroffice supplies, including postage, totaled $5,200 for the year. In addition, Ms.Chen spent $8,500 during the year on tax-deductible travel and entertainmentassociated with client visits and new business development. Lease payments forCHAPTER 2Financial Statements and Analysis79the office space rented (a tax-deductible expense) were $1,350 per month. Depreciation expense on the office furniture and fixtures was $7,800 for the year. During the year, Ms. Chen paid interest of $7,500 on the $60,000 borrowed to startthe business. She paid an average tax rate of 30 percent during 2003.a. Prepare an income statement for Cathy Chen, CPA, for the year endedDecember 31, 2003.b. Evaluate her 2003 financial performance.LG124Calculation of EPS and retained earnings Philagem, Inc., ended 2003 with netprofit before taxes of $218,000. The company is subject to a 40% tax rate andmust pay $32,000 in preferred stock dividends before distributing any earningson the 85,000 shares of common stock currently outstanding.a. Calculate Philagems 2003 earnings per share (EPS).b. If the firm paid common stock dividends of $0.80 per share, how many dollars would go to retained earnings?LG125Balance sheet preparation Use the appropriate items from the following list toprepare in good form Owen Davis Companys balance sheet at December 31,2003.ItemAccounts payableAccounts receivableAccrualsValue ($000) atDecember 31, 2003$ 22045055Accumulated depreciation265Buildings225Cash215Common stock (at par)Cost of goods soldDepreciation expenseEquipment902,50045140Furniture and fixtures170General expense320Inventories375Land100Long-term debts420Machinery420Marketable securitiesNotes payable75475Paid-in capital in excess of par360Preferred stock100Retained earningsSales revenueVehicles2103,6002580PART 1Introduction to Managerial FinanceLG126Impact of net income on a firms balance sheet Conrad Air, Inc., reported netincome of $1,365,000 for the year ended December 31, 2003. Show the effect ofthese funds on the firms balance sheet for the previous year (below) in each ofthe scenarios following the balance sheet.Conrad Air, Inc.Balance Sheetas of December 31, 2003AssetsLiabilities and Stockholders EquityCash$ 120,000Marketable securities35,000Accounts receivable45,000Inventories130,000Current assetsEquipment$ 330,000$2,970,000Buildings1,600,000Fixed assetsAccounts payable$Short-term notes70,00055,000Current liabilities$ 125,000Long-term debt$2,700,000Total liabilities$2,825,000Common stock$ 500,000Retained earnings1,575,000Stockholders equity$2,075,000$4,900,000Total assets$4,570,000Total liabilities and equity$4,900,000a. Conrad paid no dividends during the year and invested the funds in marketable securities.b. Conrad paid dividends totaling $500,000 and used the balance of the netincome to retire (pay off) long-term debt.c. Conrad paid dividends totaling $500,000 and invested the balance of the netincome in building a new hangar.d. Conrad paid out all $1,365,000 as dividends to its stockholders.LG127Initial sale price of common stock Beck Corporation has one issue of preferredstock and one issue of common stock outstanding. Given Becks stockholdersequity account that follows, determine the original price per share at which thefirm sold its single issue of common stock.Stockholders Equity ($000)Preferred stockCommon stock ($0.75 par, 300,000 shares outstanding)Paid-in capital in excess of par on common stockRetained earningsTotal stockholders equityLG128$ 1252252,625900$3,875Statement of retained earnings Hayes Enterprises began 2003 with a retainedearnings balance of $928,000. During 2003, the firm earned $377,000 aftertaxes. From this amount, preferred stockholders were paid $47,000 in dividends. At year-end 2003, the firms retained earnings totaled $1,048,000. Thefirm had 140,000 shares of common stock outstanding during 2003.CHAPTER 2Financial Statements and Analysis81a. Prepare a statement of retained earnings for the year ended December 31,2003, for Hayes Enterprises. (Note: Be sure to calculate and include theamount of cash dividends paid in 2003.)b. Calculate the firms 2003 earnings per share (EPS).c. How large a per-share cash dividend did the firm pay on common stock during 2003?LG129Changes in stockholders equity Listed are the equity sections of balance sheetsfor years 2002 and 2003 as reported by Mountain Air Ski Resorts, Inc. Theoverall value of stockholders equity has risen from $2,000,000 to $7,500,000.Use the statements to discover how and why this happened.Mountain Air Ski Resorts, Inc.Balance Sheets (partial)Stockholders Equity20022003Common stock ($1.00 par)Authorized5,000,000 sharesOutstanding 1,500,000 shares 2003500,000 shares 2002$1,500,000$ 500,000Paid-in capital in excess of par500,000Retained earnings4,500,0001,000,0001,500,000$2,000,000Total stockholders equity$7,500,000The company paid total dividends of $200,000 during fiscal 2003.a. What was Mountain Airs net income for fiscal 2003?b. How many new shares did the corporation issue and sell during theyear?c. At what average price per share did the new stock sold during 2003 sell?d. At what price per share did Mountain Airs original 500,000 shares sell?LG2LG3LG4LG5210Ratio comparisons Robert Arias recently inherited a stock portfolio from hisuncle. Wishing to learn more about the companies that he is now invested in,Robert performs a ratio analysis on each one and decides to compare them toeach other. Some of his ratios are listed below.IslandElectric UtilityBurgerHeavenFinkSoftwareRolandMotorsCurrent ratio220.127.116.11.5Quick ratio0.900.825.23.7Debt ratio0.680.460Net profit margin6.2%14.3%Ratio28.5%0.358.4%Assuming that his uncle was a wise investor who assembled the portfolio withcare, Robert finds the wide differences in these ratios confusing. Help him out.82PART 1Introduction to Managerial Financea. What problems might Robert encounter in comparing these companies toone another on the basis of their ratios?b. Why might the current and quick ratios for the electric utility and thefast-food stock be so much lower than the same ratios for the othercompanies?c. Why might it be all right for the electric utility to carry a large amount ofdebt, but not the software company?d. Why wouldnt investors invest all of their money in software companiesinstead of in less profitable companies? (Focus on risk and return.)LG3211Liquidity management Bauman Companys total current assets, total currentliabilities, and inventory for each of the past 4 years follow:Item2000Total current assets200120022003$16,950$21,900$22,500$27,000Total current liabilities9,00012,60012,60017,400Inventory6,0006,9006,9007,200a. Calculate the firms current and quick ratios for each year. Compare theresulting time series for these measures of liquidity.b. Comment on the firms liquidity over the 20002003 period.c. If you were told that Bauman Companys inventory turnover for eachyear in the 20002003 period and the industry averages were as follows,would this information support or conflict with your evaluation in part b?Why?Inventory turnover2000Bauman Company212200220036.36.87.06.410.6Industry averageLG3200111.210.811.0Inventory management Wilkins Manufacturing has sales of $4 million and agross profit margin of 40%. Its end-of-quarter inventories areQuarterInventory1$ 400,0002800,00031,200,0004200,000a. Find the average quarterly inventory and use it to calculate the firms inventory turnover and the average age of inventory.b. Assuming that the company is in an industry with an average inventoryturnover of 2.0, how would you evaluate the activity of Wilkins inventory?CHAPTER 2LG3213Financial Statements and Analysis83Accounts receivable management An evaluation of the books of Blair Supply,which follows, gives the end-of-year accounts receivable balance, which isbelieved to consist of amounts originating in the months indicated. The companyhad annual sales of $2.4 million. The firm extends 30-day credit terms.Month of originAmounts receivableJuly$ 3,875August2,000September34,025October15,100November52,000December193,000Year-end accounts receivable$300,000a. Use the year-end total to evaluate the firms collection system.b. If 70% of the firms sales occur between July and December, would thisaffect the validity of your conclusion in part a? Explain.LG3214Interpreting liquidity and activity ratios The new owners of Bluegrass NaturalFoods, Inc., have hired you to help them diagnose and cure problems that thecompany has had in maintaining adequate liquidity. As a first step, you performa liquidity analysis. You then do an analysis of the companys short-term activityratios. Your calculations and appropriate industry norms are listed.RatioBluegrassIndustry normCurrent ratio4.54.0Quick ratio2.03.1Inventory turnover6.010.4Average collection period73 days52 daysAverage payment period31 days40 daysa. What recommendations relative to the amount and the handling of inventorycould you make to the new owners?b. What recommendations relative to amount and handling of accounts receivable could you make to the new owners?c. What recommendations relative to amount and handling of accounts payablecould you make to the new owners?d. What results, overall, would you hope your recommendations wouldachieve? Why might your recommendations not be effective?LG4215Debt analysis Springfield Bank is evaluating Creek Enterprises, which hasrequested a $4,000,000 loan, to assess the firms financial leverage and financialrisk. On the basis of the debt ratios for Creek, along with the industry averagesand Creeks recent financial statements (which follow), evaluate and recommendappropriate action on the loan request.84PART 1Introduction to Managerial FinanceCreek EnterprisesIncome Statementfor the Year Ended December 31, 2003Sales revenue$30,000,000Less: Cost of goods sold21,000,000Gross profits$ 9,000,000Less: Operating expensesSelling expense$3,000,000General and administrative expensesLease expense1,800,000200,000Depreciation expense1,000,000Total operating expense6,000,000Operating profits$ 3,000,000Less: Interest expense1,000,000Net profits before taxes$ 2,000,000800,000Less: Taxes (rate = 40%)Net profits after taxes$ 1,200,000Less: Preferred stock dividendsEarnings available for common stockholders100,000$ 1,100,000Creek EnterprisesBalance SheetDecember 31, 2003AssetsLiabilities and Stockholders EquityCurrent assetsCashMarketable securitiesAccounts receivableInventoriesTotal current assetsCurrent liabilities$ 1,000,0003,000,00012,000,0007,500,000$23,500,000Gross fixed assets (at cost)aLand and buildingsMachinery and equipmentFurniture and fixturesGross fixed assetsLess: Accumulated depreciation$ 8,000,000Notes payable8,000,000AccrualsTotal current liabilitiesLong-term debt (includes financial leases)b500,000$16,500,000$20,000,000Stockholders equity$11,000,00020,500,0008,000,000$39,500,00013,000,000Net fixed assets$26,500,000Total assets$50,000,000aTheAccounts payablePreferred stock (25,000 shares,$4 dividend)$ 2,500,000Common stock (1 million shares at $5 par)5,000,000Paid-in capital in excess of par value4,000,000Retained earningsTotal stockholders equityTotal liabilities and stockholders equity2,000,000$13,500,000$50,000,000firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of the lease have yet to run.annual principal payments are $800,000.bRequiredNote: Industry averages appear at the top of the following page.CHAPTER 2Financial Statements and Analysis85Industry averagesDebt ratio2167.30Fixed-payment coverage ratioLG50.51Times interest earned ratio1.85Common-size statement analysis A common-size income statement for CreekEnterprises 2002 operations follows. Using the firms 2003 income statementpresented in Problem 215, develop the 2003 common-size income statementand compare it to the 2002 statement. Which areas require further analysis andinvestigation?Creek EnterprisesCommon-size Income Statementfor the Year Ended December 31, 2002Sales revenue ($35,000,000)100.0%Less: Cost of goods sold65.9Gross profits34.1%Less: Operating expensesSelling expense12.7%General and administrative expenses6.3Lease expense0.6Depreciation expense3.6Total operating expense23.2Operating profits10.9%Less: Interest expense1.5Net profits before taxes9.4%Less: Taxes (rate40%)3.8Net profits after taxes5.6%Less: Preferred stock dividendsLG4LG52170.1Earnings available for common stockholders5.5%The relationship between financial leverage and profitability Pelican Paper,Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers.Some financial statement values for each company follow. Use them in a ratioanalysis that compares their financial leverage and profitability.ItemTotal assetsPelican Paper, Inc.Timberland Forest, Inc.$10,000,000$10,000,000Total equity (all common)9,000,0005,000,000Total debt1,000,0005,000,000100,000500,000Annual interestTotal sales$25,000,000$25,000,000EBIT6,250,0006,250,000Net income3,690,0003,450,00086PART 1Introduction to Managerial Financea. Calculate the following debt and coverage ratios for the two companies.Discuss their financial risk and ability to cover the costs in relation to eachother.(1) Debt ratio(2) Times interest earned ratiob. Calculate the following profitability ratios for the two companies. Discusstheir profitability relative to each other.(1) Operating profit margin(2) Net profit margin(3) Return on total assets(4) Return on common equityc. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberlands investorsundertake when they choose to purchase its stock instead of Pelicans?LG6218Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 infiscal year 2003. Some ratios for the company are listed below. Use this information to determine the dollar values of various income statement and balancesheet accounts as requested.McDougal Printing, Inc.Year Ended December 31, 2003Sales$40,000,000Gross profit margin80%Operating profit margin35%Net profit margin8%Return on total assets16%Return on common equity20%Total asset turnoverAverage collection period262.2 daysCalculate values for the following:a. Gross profitsb. Cost of goods soldc. Operating profitsd. Operating expensese. Earnings available for common stockholdersf. Total assetsg. Total common stock equityh. Accounts receivableLG6219Cross-sectional ratio analysis Use the following financial statements for FoxManufacturing Company for the year ended December 31, 2003, along with theindustry average ratios also given in what follows, to:a. Prepare and interpret a complete ratio analysis of the firms 2003 operations.b. Summarize your findings and make recommendations.CHAPTER 2Financial Statements and AnalysisFox Manufacturing CompanyIncome Statementfor the Year Ended December 31, 2003Sales revenue$600,000Less: Cost of goods sold460,000Gross profits$140,000Less: Operating expensesGeneral and administrative expensesDepreciation expense$30,00030,000Total operating expenseOperating profits60,000$ 80,000Less: Interest expenseNet profits before taxesLess: Taxes10,000$ 70,00027,100Net profits after taxes (earnings availablefor common stockholders)Earnings per share (EPS)$ 42,900$2.15Fox Manufacturing CompanyBalance SheetDecember 31, 2003AssetsCashMarketable securities$ 15,0007,200Accounts receivable34,100Inventories82,000Total current assets$138,300Net fixed assets$270,000Total assets$408,300Liabilities and Stockholders EquityAccounts payableNotes payableAccrualsTotal current liabilitiesLong-term debt$ 57,00013,0005,000$ 75,000$150,000Stockholders equityCommon stock equity (20,000 shares outstanding)Retained earningsTotal stockholders equityTotal liabilities and stockholders equity$110,20073,100$183,300$408,300Note: Industry averages appear at the top of the following page.8788PART 1Introduction to Managerial FinanceRatioIndustry average, 2003Current ratioQuick ratioInventory turnover aAverage collection periodaTotal asset turnoverDebt ratioTimes interest earned ratioGross profit marginOperating profit marginNet profit marginReturn on total assets (ROA)Return on common equity (ROE)Earnings per share (EPS)aBasedLG62202.350.874.5535.3 days1.090.30012.30.2020.1350.0910.0990.167$3.10on a 360-day year and on end-of-year figures.Financial statement analysis The financial statements of Zach Industries for theyear ended December 31, 2003, follow.Zach IndustriesIncome Statementfor the Year Ended December 31, 2003Sales revenueLess: Cost of goods soldGross profitsZach IndustriesBalance SheetDecember 31, 2003$160,000106,000$ 54,000Less: Operating expensesSelling expense$ 16,000General and administrative expenses10,000Lease expense1,000Depreciation expenseTotal operating expenseOperating profits10,000$ 37,000$ 17,000Less: Interest expenseNet profits before taxes6,100$ 10,900Less: TaxesNet profits after taxes4,360$AssetsCashMarketable securities$5001,000Accounts receivable25,000Inventories45,500Total current assetsLandBuildings and equipmentLess: Accumulated depreciationNet fixed assetsTotal assets$ 72,000$ 26,00090,00038,000$ 78,000$150,000Liabilities and Stockholders Equity6,540Accounts payableNotes payableTotal current liabilities$ 22,00047,000$ 69,000Long-term debt$ 22,950Common stocka$ 31,500Retained earnings$ 26,550Total liabilities and stockholders equity$150,000aThefirms 3,000 outstanding shares of common stock closed2003 at a price of $25 per share.CHAPTER 2Financial Statements and Analysis89a. Use the preceding financial statements to complete the following table.Assume that the industry averages given in the table are applicable for both2002 and 2003.RatioIndustryaverageActual 2002Current ratioQuick ratioInventory turnoveraAverage collection periodaDebt ratioTimes interest earned ratioGross profit marginNet profit marginReturn on total assetsReturn on common equityMarket/book ratio1.800.702.5037 days65%3.838%3.5%4.0%9.5%1.11.840.782.5936 days67%4.040%3.6%4.0%8.0%1.2aBasedActual 2003on a 360-day year and on end-of-year figures.b. Analyze Zach Industries financial condition as it is related to (1) liquidity,(2) activity, (3) debt, (4) profitability, and (5) market. Summarize the companys overall financial condition.LG6221IntegrativeComplete ratio analysis Given the following financial statements,historical ratios, and industry averages, calculate Sterling Companys financialratios for the most recent year. Analyze its overall financial situation from botha cross-sectional and a time-series viewpoint. Break your analysis into evaluations of the firms liquidity, activity, debt, profitability, and market.Sterling CompanyIncome Statementfor the Year Ended December 31, 2003Sales revenueLess: Cost of goods soldGross profitsLess: Operating expensesSelling expenseGeneral and administrative expensesLease expenseDepreciation expenseTotal operating expenseOperating profitsLess: Interest expenseNet profits before taxesLess: Taxes (rate = 40%)Net profits after taxesLess: Preferred stock dividendsEarnings available for common stockholdersEarnings per share (EPS)$10,000,0007,500,000$ 2,500,000$300,000650,00050,000200,0001,200,000$ 1,300,000200,000$ 1,100,000440,000$ 660,00050,000$ 610,000$3.0590PART 1Introduction to Managerial FinanceSterling CompanyBalance SheetDecember 31, 2003AssetsLiabilities and Stockholders EquityCurrent assetsCurrent liabilitiesCash$200,000Marketable securities50,000Accounts receivable800,000Inventories950,000Total current assetsGross fixed assets (atcost)aLess: Accumulated depreciation$ 2,000,000$12,000,000Accounts payableb$900,000Notes payable200,000Accruals100,000Total current liabilities$ 1,200,000Long-term debt (includes financial leases)c$ 3,000,000Stockholders equity3,000,000Preferred stock (25,000 shares, $2 dividend)Net fixed assets$ 9,000,000Other assets$ 1,000,000Paid-in capital in excess of par valueTotal assets$12,000,000$ 1,000,000Common stock (200,000 shares at $3 par)dRetained earnings600,0005,200,0001,000,000Total stockholders equity$ 7,800,000Total liabilities and stockholders equity$12,000,000aThefirm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run.credit purchases of $6,200,000 were made during the year.cThe annual principal payment on the long-term debt is $100,000.dOn December 31, 2003, the firms common stock closed at $39.50 per share.bAnnualHistorical and Industry Average Ratios for Sterling CompanyRatioActual 2001Actual 2002Industry average, 2003Current ratio1.401.551.85Quick ratio1.000.921.05Inventory turnover9.529.218.60Average collection period45.0 days36.4 days35.0 daysAverage payment period58.5 days60.8 days45.8 daysTotal asset turnover0.740.800.74Debt ratio0.200.200.30Times interest earned ratio126.96.36.199Fixed-payment coverage ratio22.214.171.124Gross profit margin0.300.270.25Operating profit margin0.120.120.10Net profit margin0.0620.0620.053Return on total assets (ROA)0.0450.0500.040Return on common equity (ROE)0.0610.0670.066Earnings per share (EPS)$1.75$2.20$1.50Price/earnings (P/E) ratio12.010.511.2Market/book (M/B) ratio1.201.051.10CHAPTER 2LG6222Financial Statements and Analysis91Dupont system of analysis Use the following ratio information for JohnsonInternational and the industry averages for Johnsons line of business to:a. Construct the DuPont system of analysis for both Johnson and theindustry.b. Evaluate Johnson (and the industry) over the 3-year period.c. Indicate in which areas Johnson requires further analysis. Why?200120022003Financial leverage multiplier1.751.751.85Net profit margin0.0590.0580.049Total asset turnover184.108.40.206Financial leverage multiplier1.671.691.64Net profit margin0.0540.0470.041Total asset turnover2.052.132.15JohnsonIndustry AveragesLG6223Complete ratio analysis, recognizing significant differences Home Health, Inc.,has come to Jane Ross for a yearly financial checkup. As a first step, Jane hasprepared a complete set of ratios for fiscal years 2002 and 2003. She will usethem to look for significant changes in the companys situation from one year tothe next.Home Health, Inc.Financial RatiosRatio20022003Current ratio3.253.00Quick ratio2.502.20Inventory turnover12.8010.30Average collection period42 days31 daysTotal asset turnover1.402.00Debt ratio0.450.62Times interest earned ratio4.003.85Gross profit margin68%65%Operating profit margin14%16%Net profit margin8.3%8.1%Return on total assets11.6%16.2%Return on common equity21.1%42.6%Price/earnings ratio10.7Market/book ratio1.409.81.2592PART 1Introduction to Managerial Financea. In order to focus on the degree of change, calculate the year-to-year proportional change by subtracting the year 2002 ratio from the year 2003 ratio,then dividing the difference by the year 2002 ratio. Multiply the result by100. Preserve the positive or negative sign. The result is the percentagechange in the ratio from 2002 to 2003. Calculate the proportional change forthe ratios shown here.b. For any ratio that shows a year-to-year difference of 10% or more, statewhether the difference is in the companys favor or not.c. For the most significant changes (25% or more), look at the other ratios andcite at least one other change that may have contributed to the change in theratio that you are discussing.CHAPTER 2 CASEAssessing Martin ManufacturingsCurrent Financial PositionTerri Spiro, an experienced budget analyst at Martin ManufacturingCompany, has been charged with assessing the firms financial performanceduring 2003 and its financial position at year-end 2003. To complete this assignment, she gathered the firms 2003 financial statements, which follow. In addition, Terri obtained the firms ratio values for 2001 and 2002, along with the2003 industry average ratios (also applicable to 2001 and 2002). These are presented in the table on page 94.Martin Manufacturing CompanyIncome Statementfor the Year Ended December 31, 2003Sales revenue$5,075,000Less: Cost of goods sold3,704,000Gross profits$1,371,000Less: Operating expensesSelling expense$650,000General and administrative expenses416,000Depreciation expense152,000Total operating expenseOperating profits1,218,000$ 153,000Less: Interest expenseNet profits before taxesLess: Taxes (rate93,000$60,000$36,000$33,00024,00040%)Net profits after taxesLess: Preferred stock dividendsEarnings available for common stockholdersEarnings per share (EPS)3,000$0.33CHAPTER 2Financial Statements and AnalysisMartin Manufacturing CompanyBalance SheetsDecember 31Assets20032002Current assetsCash$Accounts receivableGross fixed assets (at cost)$24,100763,900700,625763,445$1,531,181$1,551,445$2,093,819$1,691,707InventoriesTotal current assets25,000805,556Less: Accumulated depreciation500,000348,000Net fixed assets$1,593,819$1,343,707Total assets$3,125,000$2,895,152$ 230,000$ 400,500Liabilities and Stockholders EquityCurrent liabilitiesAccounts payableNotes payable311,000Total current liabilitiesLong-term debtTotal liabilities370,00075,000Accruals100,902$ 616,000$ 871,402$1,165,250$ 700,000$1,781,250$1,571,402$$Stockholders equityPreferred stock (2,500 shares, $1.20 dividend)Common stock (100,000 shares at $4 par)a50,000400,00050,000400,000Paid-in capital in excess of par value593,750593,750Retained earnings300,000280,000$1,343,750$1,323,750$3,125,000$2,895,152Total stockholders equityTotal liabilities and stockholders equityaThefirms 100,000 outstanding shares of common stock closed 2003 at a price of $11.38per share.Note: Industry historical ratios appear at the top of the following page.9394PART 1Introduction to Managerial FinanceMartin Manufacturing CompanyHistorical ratiosRatioActual2001Actual2002Actual2003Industry average2003Current ratio1.71.8Quick ratio1.00.91.2Inventory turnover (times)5.25.010.2Average collection periodTotal asset turnover (times)Debt ratioTimes interest earned ratio50 days55 days1.546 days1.51.52.045.8%54.3%24.5%18.104.22.1687.5%28.0%26.0%Net profit margin1.1%1.0%1.2%Return on total assets (ROA)1.7%1.5%2.4%Return on common equity (ROE)3.1%3.3%Gross profit margin3.2%Price/earnings (P/E) ratio33.538.743.4Market/book (M/B) ratio1.01.11.2Requireda. Calculate the firms 2003 financial ratios, and then fill in the preceding table.b. Analyze the firms current financial position from both a cross-sectional anda time-series viewpoint. Break your analysis into evaluations of the firmsliquidity, activity, debt, profitability, and market.c. Summarize the firms overall financial position on the basis of your findingsin part b.WEB EXERCISEWWWGo to Web site www.yahoo.com. On the left side of the Yahoo! home pagescreen, click on the Finance category under Business and Economy. On the nextscreen click on Y! Finance.Using this screen, click on Symbol Lookup and find the symbol for Southwest Airlines. Click on this symbol to find the latest trading data for SouthwestAirlines.1. What was the selling price for the last sale of Southwests common stock?How much in dollars per share was the change?2. What was the number of shares sold in this trade?In the More Info box, you will see Profile. Click on it, and scroll down to Statistics at a Glance.3. What was the amount of Southwests sales? What was its after-tax income?4. What were Southwests earnings per share? What was its book value pershare?CHAPTER 2Financial Statements and Analysis955. How many shares of stock does Southwest have outstanding?6. What were the values of the following ratios for Southwest?a. Current ratiob. Operating profit marginc. Debt/equity ratiod. Return on equitye. What other information would you need to evaluate Southwests financial performance on the basis of these ratios?7. Find More from Market Guide and click on Ratio Comparisons. Using thesedata, summarize Southwests performance.Remember to check the books Web site atwww.aw.com/gitmanfor additional resources, including additional Web exercises....
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