Chapter 13
Analysis of Financial Statements

13-1 a. A liquidity ratio is a ratio that shows the relationship of a firm’s cash and other current assets to its current liabilities. The current ratio is found by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. The quick, or acid test, ratio is found by taking current assets less inventories and then dividing by current liabilities.

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

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

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

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

f. Trend analysis is an analysis of a firm’s financial ratios over time. It is used to estimate the likelihood of improvement or deterioration in its financial situation. Comparative ratio analysis is when a firm compares its ratios to other leading companies in the same industry. This technique is also known as benchmarking.

g. The Du Pont chart is a chart designed to show the relationships among return on investment, asset turnover, the profit margin, and leverage. The Du Pont equation is a formula, which shows that the rate of return on assets can be found as the product of the profit margin times the total assets turnover.

h. Window dressing is a technique employed by firms to make their financial statements look better than they really are. Seasonal factors can distort ratio analysis. At certain times of the year a firm may have excessive inventories in preparation of a “season” of high demand. Therefore an inventory turnover ratio taken at this time as opposed to after the season will be radically distorted.

13-2 The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Long-term creditors are more interested in the debt ratio, TIE, and fixed-charge coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the liquidity ratios.

13-3 Given that sales have not changed, a decrease in the total assets turnover means that the company’s assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies that the company increased its current assets. Since the company’s current ratio increased, and yet, its quick ratio is unchanged means that the company has increased its inventories.

13-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin, and vice versa.

13-5 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary unless averages (monthly ones are best) are used.

b. Common equity is determined at a point in time, say December 31, 2004. Profits are earned over time, say during 2004. If a firm is growing rapidly, year-end equity will be much larger than beginning-of-year equity, so the calculated rate of return on equity will be different depending on whether end-of-year, beginning-of-year, or average common equity is used as the denominator. Average common equity is conceptually the best figure to use. In public utility rate cases, people are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on equity appear excessive or inadequate. Similar problems can arise when a firm is being evaluated.

13-6 Firms within the same industry may employ different accounting techniques, which make it difficult to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the same industry differ in their other investments. For example, comparing Pepsico and Coca-Cola may be misleading because apart from their soft drink business, Pepsi also owns other businesses such as Frito-Lay, Pizza Hut, Taco Bell, and KFC.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

13-1 CA = \$3,000,000; = 1.5; = 1.0;

CL = ?; I = ?

13-2 DSO = 40 days; ADS = \$20,000; AR = ?

13-3 A/E = 2.4; D/A = ?

13-4 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; A/E = ?
ROA = NI/A; PM = NI/S; ROE = NI/E

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

ROE = PM ? S/TA ? TA/E
NI/E = NI/S ? S/TA ? TA/E
15% = 2% ? 5 ? TA/E
15% = 10% ? TA/E
TA/E = 1.5.

13-5 We are given ROA = 3% and Sales/Total assets = 1.5?.

From Du Pont equation: ROA = Profit margin ? Total assets turnover
3% = Profit margin (1.5)
Profit margin = 3%/1.5 = 2%.

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

Alternatively,

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

Take reciprocal:

E/TA = 3/5 = 60%;

therefore,

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

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

13-6 Present current ratio = = 2.5.

Minimum current ratio = = 2.0.

\$1,312,500 + ?NP = \$1,050,000 + 2?NP
?NP = \$262,500.

Short-term debt can increase by a maximum of \$262,500 without violating a 2 to 1 current ratio, assuming that the entire increase in notes payable is used to increase current assets. Since we assumed that the additional funds would be used to increase inventory, the inventory account will increase to \$637,500, and current assets will total \$1,575,000.

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

13-7 1. = 3.0? = 3.0?

Current liabilities = \$270,000.

2. = 1.4? = 1.4?

Inventories = \$432,000.

3.

\$810,000 = \$120,000 + Accounts receivable + \$432,000
Accounts receivable = \$258,000.

4. = 6.0? = 6.0?

Sales = \$2,592,000.

5. DSO = = = 36.33 days.

13-8 TIE = EBIT/INT, so find EBIT and INT.
Interest = \$500,000 ? 0.1 = \$50,000.
Net income = \$2,000,000 ? 0.05 = \$100,000.
Pre-tax income = \$100,000/(1 - T) = \$100,000/0.7 = \$142,857.

EBIT = \$142,857 + \$50,000 = \$192,857.
TIE = \$192,857/\$50,000 = 3.86?.

13-9 a. (Dollar amounts in thousands.)
Industry
Firm Average

= = 1.98? 2.0?

DSO = = = 76 days 35 days

= = 6.66? 6.7?

= = 5.50? 12.1?

= = 1.70? 3.0?

= = 1.7% 1.2%

= = 2.9% 3.6%

Industry
Firm Average

= = 7.6% 9.0%

= = 61.9% 60.0%

b. For the firm,

ROE = PM ? T.A. turnover ? EM = 1.7% ? 1.7 ? = 7.6%.
For the industry, ROE = 1.2% ? 3 ? 2.5 = 9%.

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

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

d. If 2004 represents a period of supernormal growth for the firm, ratios based on this year will be distorted and a comparison between them and industry averages will have little meaning. Potential investors who look only at 2003 ratios will be misled, and a return to normal conditions in 2005 could hurt the firm’s stock price.

13-10 1. Debt = (0.50)(Total assets) = (0.50)(\$300,000) = \$150,000.

2. Accounts payable = Debt – Long-term debt = \$150,000 - \$60,000
= \$90,000

3. Common stock = - Debt - Retained earnings
= \$300,000 - \$150,000 - \$97,500 = \$52,500.

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

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

6. Accounts receivable = (Sales/365)(DSO) = (\$450,000/365)(36.5)
= \$45,000.

7. Cash + Accounts receivable = (0.80)(Accounts payable)
Cash + \$45,000 = (0.80)(\$90,000)
Cash = \$72,000 - \$45,000 = \$27,000.

8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)
= \$300,000 - (\$27,000 + \$45,000 + \$90,000) = \$138,000.

9. Cost of goods sold = (Sales)(1 - 0.25) = (\$450,000)(0.75)
= \$337,500.

13-11 a. Here are the firm’s base case ratios and other data as compared to the industry:

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

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

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

13-12 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution to FM11 Ch 13 P12 Build a Model.xls) and on the instructor’s side of the web site, http://brigham.swcollege.com.

MINI CASE

The first part of the case, presented in chapter 3, discussed the situation that Computron Industries was in after an expansion program. Thus far, sales have not been up to the forecasted level, costs have been higher than were projected, and a large loss occurred in 2004, rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival.
Donna Jamison was brought in as assistant to Fred Campo, Computron’s chairman, who had the task of getting the company back into a sound financial position. Computron’s 2003 and 2004 balance sheets and income statements, together with projections for 2005, are shown in the following tables. Also, the tables show the 2003 and 2004 financial ratios, along with industry average data. The 2005 projected financial statement data represent Jamison’s and Campo’s best guess for 2005 results, assuming that some new financing is arranged to get the company “over the hump.”
Jamison examined monthly data for 2004 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data looked somewhat worse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were longer than Computron’s managers had anticipated. For these reasons, Jamison and Campo see hope for the company--provided it can survive in the short run.
Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.

Balance Sheets

Assets
2003

2004

2005e
Cash
\$ 9,000

\$ 7,282

\$ 14,000
Short-Term Investments.
48,600

20,000

71,632
Accounts Receivable
351,200

632,160

878,000
Inventories
715,200

1,287,360

1,716,480
Total Current Assets
\$ 1,124,000

\$ 1,946,802

\$ 2,680,112
Gross Fixed Assets
491,000

1,202,950

1,220,000
Less: Accumulated Depreciation
146,200

263,160

383,160
Net Fixed Assets
\$ 344,800

\$ 939,790

\$ 836,840
Total Assets
\$ 1,468,800

\$ 2,886,592

\$ 3,516,952

Liabilities And Equity
2003

2004

2005e
Accounts Payable
\$ 145,600

\$ 324,000

\$ 359,800
Notes Payable
200,000

720,000

300,000
Accruals
136,000

284,960

380,000
Total Current Liabilities
\$ 481,600

\$ 1,328,960

\$ 1,039,800
Long-Term Debt
323,432

1,000,000

500,000
Common Stock (100,000 Shares)
460,000

460,000

1,680,936
Retained Earnings
203,768

97,632

296,216
Total Equity
\$ 663,768

\$ 557,632

\$ 1,977,152
Total Liabilities And Equity
\$ 1,468,800

\$ 2,886,592

\$ 3,516,952

Income Statements

2003

2004

2005e
Sales
\$ 3,432,000

\$ 5,834,400

\$ 7,035,600
Cost Of Goods Sold
2,864,000

4,980,000

5,800,000
Other Expenses
340,000

720,000

612,960
Depreciation
18,900

116,960

120,000
Total Operating Costs
\$ 3,222,900

\$ 5,816,960

\$ 6,532,960
EBIT
\$ 209,100

\$ 17,440

\$ 502,640
Interest Expense
62,500

176,000

80,000
EBT
\$ 146,600

\$ (158,560)

\$ 422,640
Taxes (40%)
58,640

(63,424)

169,056
Net Income
\$ 87,960

\$ (95,136)

\$ 253,584

Other Data
2003

2004

2005e
Stock Price
\$ 8.50

\$ 6.00

\$ 12.17
Shares Outstanding
100,000

100,000

250,000
EPS
\$ 0.880

\$ (0.951)

\$ 1.014
DPS
\$ 0.220

\$ 0.110

\$ 0.220
Tax Rate
40%

40%

40%
Book Value Per Share
\$ 6.638

\$ 5.576

\$ 7.909
Lease Payments
\$ 40,000

\$ 40,000

\$ 40,000

Ratio Analysis
2003

2004

2005e
Industry Average
Current
2.3

1.5

2.58
2.7
Quick
0.8

0.5

0.93
1.0
Inventory Turnover
4.8

4.5

4.10
6.1
Days Sales Outstanding
37.4

39.5

45.5
32.0
Fixed Assets Turnover
10.0

6.2

8.41
7.0
Total Assets Turnover
2.3

2.0

2.00
2.5
Debt Ratio
54.8%

80.7%

43.8%
50.0%
TIE
3.3

0.1

6.3
6.2
EBITDA Coverage
2.6

0.8

5.5
8.0
Profit Margin
2.6%

-1.6%

3.6%
3.6%
Basic Earning Power
14.2%

0.6%

14.3%
17.8%
ROA
6.0%

-3.3%

7.2%
9.0%
ROE
13.3%

-17.1%

12.8%
17.9%
Price/Earnings (P/E)
9.7

-6.3

12.0
16.2
Price/Cash Flow
8.0

27.5

8.1
7.6
Market/Book
1.3

1.1

1.5
2.9

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

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

b. Calculate the 2005 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity position in 2003, 2004, and as projected for 2005? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the liquidity ratios?

Answer: Current Ratio05 = Current Assets/Current Liabilities
= \$2,680,112/\$1,039,800 = 2.58?.

Quick Ratio05 = (Current Assets – Inventory)/Current Liabilities
= (\$2,680,112 - \$1,716,480)/\$1,039,800 = 0.93?.

The company’s current and quick ratios are higher relative to its 2003 current and quick ratios; they have improved from their 2004 levels. Both ratios are below the industry average, however.

c. Calculate the 2005 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Computron’s utilization of assets stack up against other firms in its industry?

= \$7,035,600/\$1,716,480 = 4.10?.

DSO05 = Receivables/(Sales/365)
= \$878,000/(\$7,035,600/365) = 45.5 Days.

Fixed Assets Turnover05 = Sales/Net Fixed Assets
= \$7,035,600/\$836,840 = 8.41?.

Total Assets Turnover05 = Sales/Total Assets
= \$7,035,600/\$3,516,952 = 2.0?.

The firm’s inventory turnover ratio has been steadily declining, while its days sales outstanding has been steadily increasing. While the firm’s fixed assets turnover ratio is below its 2003 level, it is above the 2004 level. The firm’s total assets turnover ratio is below its 2003 level and equal to its 2004 level.
The firm’s inventory turnover and total assets turnover are below the industry average. The firm’s days sales outstanding is above the industry average (which is bad); however, the firm’s fixed assets turnover is above the industry average. (This might be due to the fact that Computron is an older firm than most other firms in the industry, in which case, its fixed assets are older and thus have been depreciated more, or that Computron’s cost of fixed assets were lower than most firms in the industry.)

d. Calculate the 2005 debt, times-interest-earned, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?

Answer: Debt Ratio05 = Total Liabilities/Total Assets
= (\$1,039,800 + \$500,000)/\$3,516,952 = 43.8%.
Tie05 = EBIT/Interest = \$502,640/\$80,000 = 6.3?.

EBITDA Coverage05 = /
= (\$502,640 + \$120,000 + \$40,000)/(\$80,000 + \$40,000) = 5.5?.

The firm’s debt ratio is much improved from 2004, and is still lower than its 2002 level and the industry average. The firm’s TIE and EBITDA coverage ratios are much improved from their 2003 and 2004 levels. The firm’s TIE is better than the industry average, but the EBITDA coverage is lower, reflecting the firm’s higher lease obligations.

e. Calculate the 2005 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?

Answer: Profit Margin05 = Net Income/Sales = \$253,584/\$7,035,600 = 3.6%.

Basic Earning Power05 = EBIT/Total Assets = \$502,640/\$3,516,952
= 14.3%.

ROA05 = Net Income/Total Assets = \$253,584/\$3,516,952 = 7.2%.

ROE05 = Net Income/Common Equity = \$253,584/\$1,977,152 = 12.8%.

The firm’s profit margin is above 2003 and 2004 levels and is at the industry average. The basic earning power, ROA, and ROE ratios are above both 2003 and 2004 levels, but below the industry average due to poor asset utilization.

f. Calculate the 2005 price/earnings ratio, price/cash flow ratios, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

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

Price/Earnings05 = Price Per Share/Earnings Per Share
= \$12.17/\$1.0143 = 12.0?.

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

Cash Flow/Share05 = (NI + DEP)/Shares
= (\$253,584 + \$120,000)/250,000
= \$1.49.

Price/Cash Flow = \$12.17/\$1.49 = 8.2?.

BVPS = Common Equity/Shares Outstanding
= \$1,977,152/250,000 = \$7.91.

Market/Book = Market Price Per Share/Book Value Per Share
= \$12.17/\$7.91 = 1.54x.

Both the P/E ratio and BVPS are above the 2003 and 2004 levels but below the industry average.

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

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

Common Size Balance Sheets
Assets

2003

2004

2005e
Ind.
Cash
0.6%

0.3%

0.4%
0.3%
Short Term Investments
3.3%

0.7%

2.0%
0.3%
Accounts Receivable
23.9%

21.9%

25.0%
22.4%
Inventories
48.7%

44.6%

48.8%
41.2%
Total Current Assets
76.5%

67.4%

76.2%
64.1%
Gross Fixed Assets
33.4%

41.7%

34.7%
53.9%
Less Accumulated Depreciation
10.0%

9.1%

10.9%
18.0%
Net Fixed Assets
23.5%

32.6%

23.8%
35.9%
Total Assets
100.0%

100.0%

100.0%
100.0%

Liabilities And Equity
2003

2004

2005e
Ind.
Accounts Payable
9.9%

11.2%

10.2%
11.9%
Notes Payable
13.6%

24.9%

8.5%
2.4%
Accruals
9.3%

9.9%

10.8%
9.5%
Total Current Liabilities
32.8%

46.0%

29.6%
23.7%
Long-Term Debt
22.0%

34.6%

14.2%
26.3%
Common Stock (100,000 Shares)
31.3%

15.9%

47.8%
20.0%
Retained Earnings
13.9%

3.4%

8.4%
30.0%
Total Equity
45.2%

19.3%

56.2%
50.0%
Total Liabilities And Equity
100.0%

100.0%

100.0%
100.0%

Common Size Income Statement
2003

2004

2005e
Ind.
Sales
100.0%

100.0%

100.0%
100.0%
Cost Of Goods Sold
83.4%

85.4%

82.4%
84.5%
Other Expenses
9.9%

12.3%

8.7%
4.4%
Depreciation
0.6%

2.0%

1.7%
4.0%
Total Operating Costs
93.9%

99.7%

92.9%
92.9%
EBIT
6.1%

0.3%

7.1%
7.1%
Interest Expense
1.8%

3.0%

1.1%
1.1%
EBT
4.3%

-2.7%

6.0%
5.9%
Taxes (40%)
1.7%

-1.1%

2.4%
2.4%
Net Income
2.6%

-1.6%

3.6%
3.6%

Computron has higher proportion of inventory and current assets than industry. Computron has slightly more equity (which means less debt) than industry. Computron has more short-term debt than industry, but less long-term debt than industry. Computron has lower COGS than industry, but higher other expenses. Result is that Computron has similar EBIT as industry.

For the percent change analysis, divide all items in a row by the value in the first year of the analysis.

Percent Change Balance Sheets
Assets

2003

2004

2005e
Cash
0.0%

-19.1%

55.6%
Short Term Investments
0.0%

-58.8%

47.4%
Accounts Receivable
0.0%

80.0%

150.0%
Inventories
0.0%

80.0%

140.0%
Total Current Assets
0.0%

73.2%

138.4%
Gross Fixed Assets
0.0%

145.0%

148.5%
Less Accumulated Depreciation
0.0%

80.0%

162.1%
Net Fixed Assets
0.0%

172.6%

142.7%
Total Assets
0.0%

96.5%

139.4%

Liabilities And Equity
2003

2004

2005e
Accounts Payable
0.0%

122.5%

147.1%
Notes Payable
0.0%

260.0%

50.0%
Accruals
0.0%

109.5%

179.4%
Total Current Liabilities
0.0%

175.9%

115.9%
Long-Term Debt
0.0%

209.2%

54.6%
Common Stock (100,000 Shares)
0.0%

0.0%

265.4%
Retained Earnings
0.0%

-52.1%

45.4%
Total Equity
0.0%

-16.0%

197.9%
Total Liabilities And Equity
0.0%

96.5%

139.4%

Percent Change Income Statement
2003

2004

2005e
Sales
0.0%

70.0%

105.0%
Cost Of Goods Sold
0.0%

73.9%

102.5%
Other Expenses
0.0%

111.8%

80.3%
Depreciation
0.0%

518.8%

534.9%
Total Operating Costs
0.0%

80.5%

102.7%
EBIT
0.0%

-91.7%

140.4%
Interest Expense
0.0%

181.6%

28.0%
EBT
0.0%

-208.2%

188.3%
Taxes (40%)
0.0%

-208.2%

188.3%
Net Income
0.0%

-208.2%

188.3%

We see that 2005 sales grew 105% from 2002, and that NI grew 188% from 2003. So Computron has become more profitable. We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

h. Use the extended Du Pont equation to provide a summary and overview of Computron’s financial condition as projected for 2005. What are the firm’s major strengths and weaknesses?

Answer: Du Pont Equation = ? ?
= 3.6% ? 2.0 ? (\$3,516,952/\$1,977,152)
= 3.6% ? 2.0 ? 1.8 = 13.0%.

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

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

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

Answer: Some potential problems are listed below:

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

2. Different operating and accounting practices distort comparisons.

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

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

5. “Average” performance is not necessarily good.

6. Seasonal factors can distort ratios.

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

j. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?

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

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

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

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

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

5. Competition

6. Future prospects

7. Legal and regulatory environment