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Chapter Across the Disciplines


2
Why This Chapter Matters To You
Accounting: You need to understand the
stockholders’ report and preparation of
the four key financial statements; how
firms consolidate international financial
statements; and how to calculate and

Financial interpret financial ratios for decision
making.
Information systems: You need to under-
Statements stand what data are included in the firm’s
financial statements in order to design
systems that will supply such data to

and Analysis those who prepare the statements and to
those in the firm who use the data for ratio
calculations.
Management: You need to understand
what parties are interested in the annual
report and why; how the financial state-
ments will be analyzed by those both
inside and outside the firm to assess vari-
LEARNING GOALS ous aspects of performance; the caution
that should be exercised in using financial
Review the contents of the ratio analysis; and how the financial state-
LG1
stockholders’ report and the ments affect the value of the firm.
procedures for consolidating
Marketing: You need to understand the
international financial statements.
effects your decisions will have on the
Understand who uses financial financial statements, particularly the
LG2
ratios, and how.
income statement and the statement of
cash flows, and how analysis of ratios,
Use ratios to analyze a firm’s
LG3
liquidity and activity. especially those involving sales figures,
will affect the firm’s decisions about levels
Discuss the relationship between
LG4 of inventory, credit policies, and pricing
debt and financial leverage and the
decisions.
ratios used to analyze a firm’s debt.
Operations: You need to understand how
Use ratios to analyze a firm’s
LG5
the costs of operations are reflected in the
profitability and its market value.
firm’s financial statements and how analy-
Use a summary of financial ratios sis of ratios, particularly those involving
LG6
and the DuPont system of analysis
assets, cost of goods sold, or inventory,
to perform a complete ratio analysis.
may affect requests for new equipment or
facilities.




36
37
CHAPTER 2 Financial Statements and Analysis



A ll companies gather financial data about their operations and report this
information in financial statements for interested parties. These statements
are widely standardized, and so we can use the data in them to make compar-
isons between firms and over time. Analysis of certain items of financial data can
identify areas where the firm excels and, also, areas of opportunity for improve-
ment. This chapter reviews the content of financial statements and explains cate-
gories of financial ratios and their use.



The Stockholders’ Report
LG1

Every corporation has many and varied uses for the standardized records and
generally accepted
accounting principles (GAAP) reports of its financial activities. Periodically, reports must be prepared for regu-
The practice and procedure
lators, creditors (lenders), owners, and management. The guidelines used to pre-
guidelines used to prepare and
pare and maintain financial records and reports are known as generally accepted
maintain financial records and
accounting principles (GAAP). These accounting practices and procedures are
reports; authorized by the
authorized by the accounting profession’s rule-setting body, the Financial
Financial Accounting Standards
Board (FASB). Accounting Standards Board (FASB).
Publicly owned corporations with more than $5 million in assets and 500 or
Financial Accounting
more stockholders1 are required by the Securities and Exchange Commission
Standards Board (FASB)
(SEC)—the federal regulatory body that governs the sale and listing of securi-
The accounting profession’s
rule-setting body, which ties—to provide their stockholders with an annual stockholders’ report. The
authorizes generally accepted
annual report summarizes and documents the firm’s financial activities during the
accounting principles (GAAP).
past year. It begins with a letter to the stockholders from the firm’s president
and/or chairman of the board.
Securities and Exchange
Commission (SEC)
The federal regulatory body that
governs the sale and listing of
The Letter to Stockholders
securities.
The letter to stockholders is the primary communication from management. It
stockholders’ report
describes the events that are considered to have had the greatest impact on the
Annual report that publicly
firm during the year. It also generally discusses management philosophy, strate-
owned corporations must provide
to stockholders; it sum- WW gies, and actions, as well as plans for the coming year. Links at this book’s
marizes and documents W
Web site (www.aw.com/gitman) will take you to some representative letters to
the firm’s financial
stockholders.
activities during the past
year.

letter to stockholders
The Four Key Financial Statements
Typically, the first element of the
annual stockholders’ report and The four key financial statements required by the SEC for reporting to sharehold-
the primary communication from
ers are (1) the income statement, (2) the balance sheet, (3) the statement of
management.
retained earnings, and (4) the statement of cash flows.2 The financial statements


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 the
firm publicly sells its securities. Firms that do not meet these requirements are commonly called “closely owned”
firms.
2. Whereas these statement titles are consistently used throughout this text, it is important to recognize that in prac-
tice, companies frequently use different titles. For example, General Electric uses “Statement of Earnings” rather
than “Income Statement” and “Statement of Financial Position” rather than “Balance Sheet.” Bristol Myers Squibb
uses “Statement of Earnings and Retained Earnings” rather than “Income Statement.” Pfizer uses “Statement of
Shareholders’ Equity” rather than “Statement of Retained Earnings.”
38 PART 1 Introduction to Managerial Finance


from the 2003 stockholders’ report of Bartlett Company, a manufacturer of
metal fasteners, are presented and briefly discussed.


Income Statement
The income statement provides a financial summary of the firm’s operating results
income statement
Provides a financial summary of during a specified period. Most common are income statements covering a 1-year
the firm’s operating results
period ending at a specified date, ordinarily December 31 of the calendar year.
during a specified period.
Many 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 state-
ments are typically prepared for use by management, and quarterly statements
must be made available to the stockholders of publicly owned corporations.
Table 2.1 presents Bartlett Company’s income statements for the years ended
December 31, 2003 and 2002. The 2003 statement begins with sales revenue—
the total dollar amount of sales during the period—from which the cost of goods
sold is deducted. The resulting gross profits of $986,000 represent the amount
remaining to satisfy operating, financial, and tax costs. Next, operating expenses,
which include selling expense, general and administrative expense, lease expense,
and depreciation expense, are deducted from gross profits.3 The resulting operat-
ing profits of $418,000 represent the profits earned from producing and selling
products; this amount does not consider financial and tax costs. (Operating
profit is often called earnings before interest and taxes, or EBIT.) Next, the finan-
cial cost—interest expense—is subtracted from operating profits to find net prof-
its (or earnings) before taxes. After subtracting $93,000 in 2003 interest, Bartlett
Company had $325,000 of net profits before taxes.
Next, taxes are calculated at the appropriate tax rates and deducted to deter-
mine net profits (or earnings) after taxes. Bartlett Company’s net profits after
taxes for 2003 were $231,000. Any preferred stock dividends must be subtracted
from net profits after taxes to arrive at earnings available for common stockhold-
ers. This is the amount earned by the firm on behalf of the common stockholders
during the period.
Dividing earnings available for common stockholders by the number of
shares of common stock outstanding results in earnings per share (EPS). EPS rep-
resents the number of dollars earned during the period on behalf of each out-
standing share of common stock. In 2003, Bartlett Company earned $221,000
for its common stockholders, which represents $2.90 for each outstanding share.
dividend per share (DPS)
The dollar amount of cash The actual cash dividend per share (DPS), which is the dollar amount of cash dis-
distributed during the period on
tributed during the period on behalf of each outstanding share of common stock,
behalf of each outstanding share
paid in 2003 was $1.29.
of common stock.


Balance Sheet
balance sheet
The balance sheet presents a summary statement of the firm’s financial position
Summary statement of the firm’s
at a given point in time. The statement balances the firm’s assets (what it owns)
financial position at a given point
against its financing, which can be either debt (what it owes) or equity (what was
in time.




3. Depreciation expense can be, and frequently is, included in manufacturing costs—cost of goods sold—to calculate
gross profits. Depreciation is shown as an expense in this text to isolate its impact on cash flows.
39
CHAPTER 2 Financial Statements and Analysis


TABLE 2.1 Bartlett Company Income
Statements ($000)

For the years ended
December 31

2003 2002

Sales revenue $3,074 $2,567
Less: Cost of goods sold 2,088 1,711
Gross profits $ 986 $ 856
Less: Operating expenses
Selling expense $ 100 $ 108
General and administrative expenses 194 187
expensea
Lease 35 35
Depreciation expense 239 223
Total operating expense $ 568 $ 553
Operating profits $ 418 $ 303
Less: Interest expense 93 91
Net profits before taxes $ 325 $ 212
29%)b
Less: Taxes (rate 94 64
Net profits after taxes $ 231 $ 148
Less: Preferred stock dividends 10 10
Earnings available for common stockholders $ 221 $ 138

Earnings per share (EPS)c $ 2.90 $ 1.81
(DPS)d
Dividend per share $ 1.29 $ 0.75
aLease expense is shown here as a separate item rather than being included as
part of interest expense, as specified by the FASB for financial-reporting pur-
poses. The approach used here is consistent with tax-reporting rather than
financial-reporting procedures.
bThe 29% tax rate for 2003 results because the firm has certain special tax
write-offs that do not show up directly on its income statement.
cCalculated by dividing the earnings available for common stockholders by
the number of shares of common stock outstanding—76,262 in 2003 and
76,244 in 2002. Earnings per share in 2003: $221,000 76,262 $2.90; in
2002: $138,000 76,244 $1.81.
dCalculated by dividing the dollar amount of dividends paid to common stock-
holders by the number of shares of common stock outstanding. Dividends per
share in 2003: $98,000 76,262 $1.29; in 2002: $57,183 76,244 $0.75.




provided by owners). Bartlett Company’s balance sheets as of December 31 of
2003 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 assets
current assets
and liabilities. The current assets and current liabilities are short-term assets and
Short-term assets, expected to
liabilities. This means that they are expected to be converted into cash (current
be converted into cash within 1
year or less. assets) or paid (current liabilities) within 1 year or less. All other assets and liabil-
ities, along with stockholders’ equity, which is assumed to have an infinite life,
current liabilities
are considered long-term, or fixed, because they are expected to remain on the
Short-term liabilities, expected
firm’s books for more than 1 year.
to be paid within 1 year or less.
40 PART 1 Introduction to Managerial Finance


TABLE 2.2 Bartlett Company Balance Sheets ($000)

December 31

Assets 2003 2002

Current assets
Cash $ 363 $ 288
Marketable securities 68 51
Accounts receivable 503 365
Inventories 289 300
Total current assets $1,223 $1,004
Gross fixed assets (at cost)a
Land and buildings $2,072 $1,903
Machinery and equipment 1,866 1,693
Furniture and fixtures 358 316
Vehicles 275 314
Other (includes financial leases) 98 96
Total gross fixed assets (at cost) $4,669 $4,322
Less: Accumulated depreciation 2,295 2,056
Net fixed assets $2,374 $2,266
Total assets $3,597 $3,270

Liabilities and Stockholders’ Equity

Current liabilities
Accounts payable $ 382 $ 270
Notes payable 79 99
Accruals 159 114
Total current liabilities $ 620 $ 483
Long-term debt (includes financial leases)b $1,023 $ 967
Total liabilities $1,643 $1,450
Stockholders’ equity
Preferred stock—cumulative 5%, $100 par, 2,000 shares
authorized and issuedc $ 200 $ 200
Common stock—$2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2003: 76,262; in 2002: 76,244 191 190
Paid-in capital in excess of par on common stock 428 418
Retained earnings 1,135 1,012
Total stockholders’ equity $1,954 $1,820
Total liabilities and stockholders’ equity $3,597 $3,270

aIn2003, 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 firm’s total outstanding debt amount to $71,000.
cThe annual preferred stock dividend would be $5 per share (5% $100 par), or a total of $10,000
annually ($5 per share 2,000 shares).
41
CHAPTER 2 Financial Statements and Analysis



In Practice
FOCUS ON PRACTICE Extraordinary? Not to the FASB!
To most of us, the events of Sep- Explained Tim Lucas, chair of the appropriate for all industries. FASB
tember 11, 2001, would certainly FASB Emerging Issues Task Force, members were concerned that
qualify as extraordinary. The plane “The task force understood that companies would blame negative
crashes that took thousands of this was an extraordinary event in financial performance on the at-
lives, destroyed the World Trade the English-language sense of the tacks when in fact the costs were
Center Towers, and damaged part word. But in the final analysis, we unrelated. As one member pointed
of the Pentagon were circum- decided it wasn’t going to improve out, almost every company was af-
stances well outside what we the financial reporting system to fected in some way. Because the
consider “ordinary.” Yet, several show it [separately].” whole business climate changed,
weeks after the tragedy the The FASB task force had pre- “it almost made it ordinary.”
Financial Accounting Standards pared a draft document with Companies will, however, be
Board (FASB) announced that the guidelines on accounting for dis- able to separate costs they believe
terrorist attack did not constitute aster-related costs as extraordi- to be attributable to September 11
an extraordinary event—at least nary. As they considered how to in the footnotes to financial state-
not in accounting terms. apply these recommendations, ments and in management’s dis-
As a result, companies will they realized that the impact of the cussion of financial results.
not be able to separate costs and attack was so far-ranging that it
expenses related to the disaster as was almost impossible to divide di- Sources: Jennifer Davies, “Will Attacks
Cover Up Weak Earnings?” San Diego
extraordinary on their financial rect financial and economic ef- Union-Tribune (October 14, 2001), pp. H1, H6;
statements. Those expenses will fects from the weakening eco- Steve Liesman, “Accountants, in a Reversal,
Say Costs from the Attack Aren’t ‘Extraordi-
show up as normal operating costs nomic conditions prior to
nary,’” Wall Street Journal (October 1, 2001),
in the continuing operations sec- September 11. Nor was it possible pp. C1-2; Keith Naughton, “Out of the Ordi-
tion of the income statement. to develop one set of guidelines nary,” Newsweek (October 15, 2001), p. 9.




As is customary, the assets are listed from the most liquid—cash—down to
the least liquid. Marketable securities are very liquid short-term investments, such
as U.S. Treasury bills or certificates of deposit, held by the firm. Because they are
highly liquid, marketable securities are viewed as a form of cash (“near cash”).
Accounts receivable represent the total monies owed the firm by its customers on
credit sales made to them. Inventories include raw materials, work in process
(partially finished goods), and finished goods held by the firm. The entry for
gross fixed assets is the original cost of all fixed (long-term) assets owned by the
firm.4 Net fixed assets represent the difference between gross fixed assets and
accumulated depreciation—the total expense recorded for the depreciation of
fixed assets. (The net value of fixed assets is called their book value.)
Like assets, the liabilities and equity accounts are listed from short-term to
long-term. Current liabilities include accounts payable, amounts owed for credit
purchases by the firm; notes payable, outstanding short-term loans, typically
from commercial banks; and accruals, amounts owed for services for which a bill
long-term debt
may not or will not be received. (Examples of accruals include taxes due the gov-
Debts for which payment is not
ernment and wages due employees.) Long-term debt represents debt for which
due in the current year.



4. For convenience the term fixed assets is used throughout this text to refer to what, in a strict accounting sense, is
captioned “property, plant, and equipment.” This simplification of terminology permits certain financial concepts
to be more easily developed.
42 PART 1 Introduction to Managerial Finance


payment is not due in the current year. Stockholders’ equity represents the own-
ers’ claims on the firm. The preferred stock entry shows the historical proceeds
from the sale of preferred stock ($200,000 for Bartlett Company).
Next, the amount paid by the original purchasers of common stock is shown
by two entries: common stock and paid-in capital in excess of par on common
stock. The common stock entry is the par value of common stock. Paid-in capital
paid-in capital in excess of par
in excess of par represents the amount of proceeds in excess of the par value
The amount of proceeds in
excess of the par value received received from the original sale of common stock. The sum of the common stock
from the original sale of common
and paid-in capital accounts divided by the number of shares outstanding repre-
stock.
sents the original price per share received by the firm on a single issue of common
stock. Bartlett Company therefore received about $8.12 per share [($191,000
par $428,000 paid-in capital in excess of par) 76,262 shares] from the sale of
its common stock.
Finally, retained earnings represent the cumulative total of all earnings, net of
retained earnings
The cumulative total of all dividends, that have been retained and reinvested in the firm since its inception. It
earnings, net of dividends, that
is important to recognize that retained earnings are not cash but rather have been
have been retained and
utilized to finance the firm’s assets.
reinvested in the firm since its
Bartlett Company’s balance sheets in Table 2.2 show that the firm’s total
inception.
assets increased from $3,270,000 in 2002 to $3,597,000 in 2003. The $327,000
increase was due primarily to the $219,000 increase in current assets. The asset
increase 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 from
the statement of cash flows, which we will discuss shortly.


Statement of Retained Earnings
The statement of retained earnings reconciles the net income earned during a
statement of retained earnings
Reconciles the net income given year, and any cash dividends paid, with the change in retained earnings
earned during a given year, and
between the start and the end of that year. Table 2.3 presents this statement for
any cash dividends paid, with the
Bartlett Company for the year ended December 31, 2003. The statement shows
change in retained earnings
that the company began the year with $1,012,000 in retained earnings and had
between the start and the end of
net profits after taxes of $231,000, from which it paid a total of $108,000 in div-
that year.
idends, resulting in year-end retained earnings of $1,135,000. Thus the net
increase for Bartlett Company was $123,000 ($231,000 net profits after taxes
minus $108,000 in dividends) during 2003.


TABLE 2.3 Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended
December 31, 2003
Retained earnings balance (January 1, 2003) $1,012
Plus: Net profits after taxes (for 2003) 231
Less: Cash dividends (paid during 2003)
Preferred stock ($10)
Common stock ( 98)
Total dividends paid ( 108)
Retained earnings balance (December 31, 2003) $1,135
43
CHAPTER 2 Financial Statements and Analysis


TABLE 2.4 Bartlett Company Statement of Cash
Flows ($000) for the Year Ended
December 31, 2003

Cash Flow from Operating Activities
Net profits after taxes $231
Depreciation 239
( 138)a
Increase in accounts receivable
Decrease in inventories 11
Increase in accounts payable 112
Increase in accruals 45
Cash provided by operating activities $500

Cash Flow from Investment Activities
Increase in gross fixed assets ($347)
Change in business interests 0
Cash provided by investment activities ( 347)

Cash Flow from Financing Activities
Decrease in notes payable ($ 20)
Increase in long-term debts 56
equityb
Changes in stockholders’ 11
Dividends paid ( 108)
Cash provided by financing activities ( 61)
Net increase in cash and marketable securities $ 92
aAs is customary, parentheses are used to denote a negative number, which in this case is a
cash outflow.
bRetained earnings are excluded here, because their change is actually reflected in the
combination of the “net profits after taxes” and “dividends paid” entries.




Statement of Cash Flows
The statement of cash flows is a summary of the cash flows over the period of
statement of cash flows
Provides a summary of the firm’s concern. The statement provides insight into the firm’s operating, investment,
operating, investment, and
and financing cash flows and reconciles them with changes in its cash and mar-
financing cash flows and
ketable securities during the period. Bartlett Company’s statement of cash flows
reconciles them with changes in
for the year ended December 31, 2003, is presented in Table 2.4. Further insight
its cash and marketable securi-
into this statement is included in the discussion of cash flow of in Chapter 3.
ties during the period.



Notes to the Financial Statements
Included with published financial statements are explanatory notes keyed to the
relevant accounts in the statements. These notes to the financial statements pro-
notes to the financial statements
Footnotes detailing information vide detailed information on the accounting policies, procedures, calculations,
on the accounting policies,
and transactions underlying entries in the financial statements. Common issues
procedures, calculations, and
addressed by these notes include revenue recognition, income taxes, breakdowns
transactions underlying entries
of fixed asset accounts, debt and lease terms, and contingencies. Professional
in the financial statements.
securities analysts use the data in the statements and notes to develop estimates of
44 PART 1 Introduction to Managerial Finance


the value of securities that the firm issues, and these estimates influence the
actions of investors and therefore the firm’s share value.


Consolidating International Financial Statements
So far, we’ve discussed financial statements involving only one currency, the U.S.
dollar. The issue of how to consolidate a company’s foreign and domestic finan-
cial statements has bedeviled the accounting profession for many years. The cur-
rent policy is described in Financial Accounting Standards Board (FASB) Stan-
Financial Accounting Standards
dard No. 52, which mandates that U.S.-based companies translate their
Board (FASB) Standard No. 52
Mandates that U.S.-based foreign-currency-denominated assets and liabilities into dollars, for consolida-
companies translate their
tion with the parent company’s financial statements. This is done by converting
foreign-currency-denominated
all of a U.S. parent company’s foreign-currency-denominated assets and liabili-
assets and liabilities into dollars,
ties into dollar values using the exchange rate prevailing at the fiscal year ending
for consolidation with the parent
date (the current rate). Income statement items are treated similarly. Equity
company’s financial statements.
accounts, on the other hand, are translated into dollars by using the exchange
rate that prevailed when the parent’s equity investment was made (the historical
WW rate). Further details on this procedure can be found at the book’s Web site at
W
www.aw.com/gitman or in an intermediate accounting text.


Review Questions

2–1 Describe the purpose of each of the four major financial statements.
2–2 Why are the notes to the financial statements important to professional
securities analysts?




Using Financial Ratios
LG2

The information contained in the four basic financial statements is of major sig-
nificance to various interested parties who regularly need to have relative mea-
sures of the company’s operating efficiency. Relative is the key word here,
ratio analysis
because the analysis of financial statements is based on the use of ratios or rela-
Involves methods of calculating
tive values. Ratio analysis involves methods of calculating and interpreting finan-
and interpreting financial ratios
cial ratios to analyze and monitor the firm’s performance. The basic inputs to
to analyze and monitor the firm’s
ratio analysis are the firm’s income statement and balance sheet.
performance.



Interested Parties
Ratio analysis of a firm’s financial statements is of interest to shareholders, credi-
tors, and the firm’s own management. Both present and prospective shareholders
are interested in the firm’s current and future level of risk and return, which
directly affect share price. The firm’s creditors are interested primarily in the
short-term liquidity of the company and its ability to make interest and principal
payments. A secondary concern of creditors is the firm’s profitability; they want
45
CHAPTER 2 Financial Statements and Analysis


assurance that the business is healthy. Management, like stockholders, is con-
cerned with all aspects of the firm’s financial situation, and it attempts to produce
financial ratios that will be considered favorable by both owners and creditors. In
addition, management uses ratios to monitor the firm’s performance from period
to period.


Types of Ratio Comparisons
Ratio analysis is not merely the calculation of a given ratio. More important is
the interpretation of the ratio value. A meaningful basis for comparison is
needed to 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 Analysis
cross-sectional analysis Cross-sectional analysis involves the comparison of different firms’ financial
Comparison of different firms’
ratios at the same point in time. Analysts are often interested in how well a firm
financial ratios at the same point
has performed in relation to other firms in its industry. Frequently, a firm will
in time; involves comparing the
compare its ratio values to those of a key competitor or group of competitors that
firm’s ratios to those of other
it wishes to emulate. This type of cross-sectional analysis, called benchmarking,
firms in its industry or to industry
averages. has become very popular.
Comparison to industry averages is also popular. These figures can be found
benchmarking
in the Almanac of Business and Industrial Financial Ratios, Dun & Bradstreet’s
A type of cross-sectional
Industry Norms and Key Business Ratios, Business Month, FTC Quarterly
analysis in which the firm’s ratio
values are compared to those of Reports, Robert Morris Associates Statement Studies, Value Line, and industry
a key competitor or group of
sources.5 A sample from one available source of industry averages is given in
competitors that it wishes to
Table 2.5.
emulate.
Many people mistakenly believe that as long as the firm being analyzed has a
value “better than” the industry average, it can be viewed favorably. However,
this “better than average” viewpoint can be misleading. Quite often a ratio value
that is far better than the norm can indicate problems that, on more careful
analysis, may be more severe than had the ratio been worse than the industry
average. It is therefore important to investigate significant deviations to either
side of the industry standard.

In early 2004, Mary Boyle, the chief financial analyst at Caldwell Manufacturing,
EXAMPLE
a producer of heat exchangers, gathered data on the firm’s financial performance
during 2003, the year just ended. She calculated a variety of ratios and obtained
industry averages. She was especially interested in inventory turnover, which
reflects the speed with which the firm moves its inventory from raw materials
through production into finished goods and to the customer as a completed sale.
Generally, higher values of this ratio are preferred, because they indicate a



5. Cross-sectional comparisons of firms operating in several lines of business are difficult to perform. The use of
weighted-average industry average ratios based on the firm’s product-line mix or, if data are available, analysis of
the firm on a product-line basis can be performed to evaluate a multiproduct firm.
46 PART 1 Introduction to Managerial Finance


Industry Average Ratios (2001) for Selected Lines of Businessa
TABLE 2.5

Total
Line of business Total liabilities Return Return
(number of Current Quick Sales to Collection assets to net Return on total on net
concerns ratio ratio inventory period to sales worth on sales assets worth
reporting)b (X) (X) (X) (days) (%) (%) (%) (%) (%)

Department 6.2 1.9 6.0 2.9 34.3 19.7 4.0 8.5 14.6
stores 3.0 0.8 4.7 8.0 50.9 62.0 1.8 3.3 6.5
(167) 1.9 0.3 3.3 34.7 68.2 164.9 0.6 0.9 2.0

Electronic 3.6 1.8 19.0 34.7 36.4 121.4 7.1 11.7 23.9
computers 1.8 1.0 9.1 55.9 59.7 230.4 1.8 3.5 9.8
(91) 1.3 0.6 5.3 85.4 102.3 428.4 (0.8) (3.1) 2.0

Grocery 2.5 0.9 31.0 1.1 14.4 46.2 2.2 9.9 24.3
stores 1.5 0.4 19.7 2.9 20.3 128.4 0.8 3.9 11.1
(541) 1.0 0.2 14.0 5.8 31.3 294.2 0.3 1.0 3.8

Motor 2.0 1.0 11.2 18.5 27.9 95.9 3.7 9.7 24.1
vehicles 1.5 0.7 8.7 26.7 39.0 174.3 1.9 3.7 15.6
(38) 1.2 0.3 5.8 47.5 59.2 393.9 0.6 1.4 3.4
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 are
the 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.




quicker turnover of inventory. Caldwell Manufacturing’s calculated inventory
turnover for 2003 and the industry average inventory turnover were as follows:


Inventory turnover, 2003

Caldwell Manufacturing 14.8
Industry average 9.7



Mary’s initial reaction to these data was that the firm had managed its inven-
tory significantly better than the average firm in the industry. The turnover was
nearly 53% faster than the industry average. Upon reflection, however, she real-
ized that a very high inventory turnover could also mean very low levels of inven-
tory. The consequence of low inventory could be excessive stockouts (insufficient
inventory). Discussions with people in the manufacturing and marketing depart-
ments did in fact uncover such a problem: Inventories during the year were
extremely low, the result of numerous production delays that hindered the firm’s
ability to meet demand and resulted in lost sales. What had initially appeared to
reflect extremely efficient inventory management was actually the symptom of a
major problem.
47
CHAPTER 2 Financial Statements and Analysis


Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to
time-series analysis
Evaluation of the firm’s financial past performance, using ratios, enables analysts to assess the firm’s progress.
performance over time using Developing trends can be seen by using multiyear comparisons. As in cross-
financial ratio analysis.
sectional analysis, any significant year-to-year changes may be symptomatic of a
major problem.

Combined Analysis
The most informative approach to ratio analysis combines cross-sectional and
time-series analyses. A combined view makes it possible to assess the trend in the
behavior of the ratio in relation to the trend for the industry. Figure 2.1 depicts
this type of approach using the average collection period ratio of Bartlett Com-
pany, over the years 2000–2003. This ratio reflects the average amount of time it
takes the firm to collect bills, and lower values of this ratio generally are preferred.
The figure quickly discloses that (1) Bartlett’s effectiveness in collecting its receiv-
ables is poor in comparison to the industry, and (2) Bartlett’s trend is toward
longer collection periods. Clearly, Bartlett needs to shorten its collection period.


Cautions About Using Ratio Analysis
Before discussing specific ratios, we should consider the following cautions about
their use:

1. Ratios with large deviations from the norm only indicate symptoms of a
problem. Additional analysis is typically needed to isolate the causes of the
problem. The fundamental point is this: Ratio analysis merely directs atten-
tion to potential areas of concern; it does not provide conclusive evidence as
to the existence of a problem.
2. A single ratio does not generally provide sufficient information from which
to judge the overall performance of the firm. Only when a group of ratios is



FIGURE 2.1
Average Collection Period (days)




Combined Analysis 70
Combined cross-sectional
and time-series view of 60 Bartlett
Bartlett Company’s average
collection period, 2000–2003 50
Industry

40

30


2000 2001 2002 2003
Year
48 PART 1 Introduction to Managerial Finance


used can reasonable judgments be made. However, if an analysis is con-
cerned only with certain specific aspects of a firm’s financial position, one or
two ratios may be sufficient.
3. The ratios being compared should be calculated using financial statements
dated at the same point in time during the year. If they are not, the effects of
seasonality may produce erroneous conclusions and decisions. For example,
comparison of the inventory turnover of a toy manufacturer at the end of
June with its end-of-December value can be misleading. Clearly, the seasonal
impact of the December holiday selling season would skew any comparison
of the firm’s inventory management.
4. It is preferable to use audited financial statements for ratio analysis. If the
statements have not been audited, the data contained in them may not reflect
the firm’s true financial condition.
5. The financial data being compared should have been developed in the same
way. The use of differing accounting treatments—especially relative to inven-
tory and depreciation—can distort the results of ratio analysis, regardless of
whether cross-sectional or time-series analysis is used.
6. Results can be distorted by inflation, which can cause the book values of inven-
tory and depreciable assets to differ greatly from their true (replacement) val-
ues. Additionally, inventory costs and depreciation write-offs can differ from
their true values, thereby distorting profits. Without adjustment, inflation
tends to cause older firms (older assets) to appear more efficient and profitable
than newer firms (newer assets). Clearly, in using ratios, care must be taken to
compare older to newer firms or a firm to itself over a long period of time.


Categories of Financial Ratios
Financial ratios can be divided for convenience into five basic categories: liquid-
ity, activity, debt, profitability, and market ratios. Liquidity, activity, and debt
ratios primarily measure risk. Profitability ratios measure return. Market ratios
capture both risk and return.
As a rule, the inputs necessary to an effective financial analysis include, at a
minimum, the income statement and the balance sheet. We will use the 2003 and
2002 income statements and balance sheets for Bartlett Company, presented ear-
lier in Tables 2.1 and 2.2, to demonstrate ratio calculations. Note, however, that
the ratios presented in the remainder of this chapter can be applied to almost any
company. Of course, many companies in different industries use ratios that focus
on aspects peculiar to their industry.


Review Questions

2–3 With regard to financial ratio analysis, how do the viewpoints held by the
firm’s present and prospective shareholders, creditors, and management
differ?
2–4 What is the difference between cross-sectional and time-series ratio analy-
sis? What is benchmarking?
2–5 What types of deviations from the norm should the analyst pay primary
attention to when performing cross-sectional ratio analysis? Why?
49
CHAPTER 2 Financial Statements and Analysis


2–6 Why is it preferable to compare ratios calculated using financial state-
ments that are dated at the same point in time during the year?



Liquidity Ratios
LG3

The liquidity of a firm is measured by its ability to satisfy its short-term obliga-
liquidity
A firm’s ability to satisfy its tions as they come due. Liquidity refers to the solvency of the firm’s overall finan-
short-term obligations as they
cial position—the ease with which it can pay its bills. Because a common precur-
come due.
sor to financial distress and bankruptcy is low or declining liquidity, these ratios
are viewed as good leading indicators of cash flow problems. The two basic mea-
sures of liquidity are the current ratio and the quick (acid-test) ratio.


Current Ratio
The current ratio, one of the most commonly cited financial ratios, measures the
current ratio
A measure of liquidity calculated firm’s ability to meet its short-term obligations. It is expressed as follows:
by dividing the firm’s current
Current assets
assets by its current liabilities.
Current ratio
Current liabilities
The current ratio for Bartlett Company in 2003 is
$1,223,000
1.97
$620,000
Generally, the higher the current ratio, the more liquid the firm is considered
to be. A current ratio of 2.0 is occasionally cited as acceptable, but a value’s
acceptability depends on the industry in which the firm operates. For example, a
current ratio of 1.0 would be considered acceptable for a public utility but might
be unacceptable for a manufacturing firm. The more predictable a firm’s cash
flows, the lower the acceptable current ratio. Because Bartlett Company is in a
business with a relatively predictable annual cash flow, its current ratio of 1.97
should be quite acceptable.


Quick (Acid-Test) Ratio
The quick (acid-test) ratio is similar to the current ratio except that it excludes
quick (acid-test) ratio
A measure of liquidity calculated inventory, which is generally the least liquid current asset. The generally low liq-
by dividing the firm’s current
uidity of inventory results from two primary factors: (1) many types of inventory
assets minus inventory by its
cannot be easily sold because they are partially completed items, special-purpose
current liabilities.
items, and the like; and (2) inventory is typically sold on credit, which means that
it becomes an account receivable before being converted into cash. The quick
ratio is calculated as follows:6
Current assets Inventory
Quick ratio
Current liabilities


6. Sometimes the quick ratio is defined as (cash marketable securities accounts receivable) current liabilities. If
a firm were to show as current assets items other than cash, marketable securities, accounts receivable, and invento-
ries, its quick ratio might vary, depending on the method of calculation.
50 PART 1 Introduction to Managerial Finance


The quick ratio for Bartlett Company in 2003 is

$1,223,000 $289,000 $934,000
1.51
$620,000 $620,000

A quick ratio of 1.0 or greater is occasionally recommended, but as with the
current ratio, what value is acceptable depends largely on the industry. The quick
ratio provides a better measure of overall liquidity only when a firm’s inventory
cannot be easily converted into cash. If inventory is liquid, the current ratio is a
preferred measure of overall liquidity.



Review Question

2–7 Under what circumstances would the current ratio be the preferred mea-
sure of overall firm liquidity? Under what circumstances would the quick
ratio be preferred?




Activity Ratios
LG3

Activity ratios measure the speed with which various accounts are converted into
activity ratios
Measure the speed with which sales or cash—inflows or outflows. With regard to current accounts, measures of
various accounts are converted
liquidity are generally inadequate because differences in the composition of a
into sales or cash—inflows or
firm’s current assets and current liabilities can significantly affect its “true” liq-
outflows.
uidity. It is therefore important to look beyond measures of overall liquidity and
to assess the activity (liquidity) of specific current accounts. A number of ratios
are available for measuring the activity of the most important current accounts,
which include inventory, accounts receivable, and accounts payable.7 The effi-
ciency with which total assets are used can also be assessed.


Inventory Turnover
Inventory turnover commonly measures the activity, or liquidity, of a firm’s
inventory turnover
Measures the activity, or liquid- inventory. It is calculated as follows:
ity, of a firm’s inventory.
Cost of goods sold
Inventory turnover
Inventory



7. For convenience, the activity ratios involving these current accounts assume that their end-of-period values are
good approximations of the average account balance during the period—typically 1 year. Technically, when the
month-end balances of inventory, accounts receivable, or accounts payable vary during the year, the average bal-
ance, calculated by summing the 12 month-end account balances and dividing the total by 12, should be used
instead of the year-end value. If month-end balances are unavailable, the average can be approximated by dividing
the sum of the beginning-of-year and end-of-year balances by 2. These approaches ensure a ratio that on the average
better reflects the firm’s circumstances. Because the data needed to find averages are generally unavailable to the
external analyst, year-end values are frequently used to calculate activity ratios for current accounts.
51
CHAPTER 2 Financial Statements and Analysis


Applying this relationship to Bartlett Company in 2003 yields

$2,088,000
Inventory turnover 7.2
$289,000

The resulting turnover is meaningful only when it is compared with that of other
firms in the same industry or to the firm’s past inventory turnover. An inventory
turnover of 20.0 would not be unusual for a grocery store, whereas a common
inventory turnover for an aircraft manufacturer is 4.0.
Inventory turnover can be easily converted into an average age of inventory
average age of inventory
Average number of days’ sales by dividing it into 360—the assumed number of days in a year.8 For Bartlett
in inventory.
Company, the average age of inventory in 2003 is 50.0 days (360 7.2). This
value can also be viewed as the average number of days’ sales in inventory.


Average Collection Period
The average collection period, or average age of accounts receivable, is useful in
average collection period
The average amount of time evaluating credit and collection policies.9 It is arrived at by dividing the average
needed to collect accounts
daily sales10 into the accounts receivable balance:
receivable.
Accounts receivable
Average collection period
Average sales per day

Accounts receivable
Annual sales
360

The average collection period for Bartlett Company in 2003 is

$503,000 $503,000
58.9 days
$3,074,000 $8,539
360

On 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 firm’s
credit terms. If Bartlett Company extends 30-day credit terms to customers, an
average collection period of 58.9 days may indicate a poorly managed credit or
collection department, or both. It is also possible that the lengthened collection
period resulted from an intentional relaxation of credit-term enforcement in
response to competitive pressures. If the firm had extended 60-day credit terms,
the 58.9-day average collection period would be quite acceptable. Clearly, addi-
tional information is needed to evaluate the effectiveness of the firm’s credit and
collection policies.


8. Unless otherwise specified, a 360-day year consisting of twelve 30-day months is assumed throughout this text-
book. 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 evalua-
tion and establishment of credit and collection policies is presented in Chapter 13.
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.
52 PART 1 Introduction to Managerial Finance


Average Payment Period
The average payment period, or average age of accounts payable, is calculated in
average payment period
the same manner as the average collection period:
The average amount of time
needed to pay accounts payable.
Accounts payable
Average payment period
Average purchases per day
Accounts payable
Annual purchases
360
The difficulty in calculating this ratio stems from the need to find annual pur-
chases,11 a value not available in published financial statements. Ordinarily, pur-
chases are estimated as a given percentage of cost of goods sold. If we assume
that Bartlett Company’s purchases equaled 70 percent of its cost of goods sold in
2003, its average payment period is
$382,000 $382,000
94.1 days
$4,060
0.70 $2,088,000
360
This figure is meaningful only in relation to the average credit terms extended to
the firm. If Bartlett Company’s suppliers have extended, on average, 30-day
credit terms, an analyst would give Bartlett a low credit rating. Prospective
lenders and suppliers of trade credit are most interested in the average payment
period because it provides insight into the firm’s bill-paying patterns.

Total Asset Turnover
The total asset turnover indicates the efficiency with which the firm uses its assets
total asset turnover
Indicates the efficiency with to generate sales. Total asset turnover is calculated as follows:
which the firm uses its assets to
Sales
generate sales.
Total asset turnover
Total assets
The value of Bartlett Company’s total asset turnover in 2003 is
$3,074,000
0.85
$3,597,000
This means the company turns over its assets 0.85 times a year.
Generally, the higher a firm’s total asset turnover, the more efficiently its assets
have been used. This measure is probably of greatest interest to management,
because it indicates whether the firm’s operations have been financially efficient.


Review Question

2–8 To assess the firm’s average collection period and average payment period
ratios, what additional information is needed, and why?

11. Technically, annual credit purchases—rather than annual purchases—should be used in calculating this ratio.
For simplicity, this refinement is ignored here.
53
CHAPTER 2 Financial Statements and Analysis


Debt Ratios
LG4


The debt position of a firm indicates the amount of other people’s money being
used to generate profits. In general, the financial analyst is most concerned with
long-term debts, because these commit the firm to a stream of payments over the
long run. Because creditors’ claims must be satisfied before the earnings can be dis-
tributed to shareholders, present and prospective shareholders pay close attention
to the firm’s ability to repay debts. Lenders are also concerned about the firm’s
indebtedness. Management obviously must be concerned with indebtedness.
In general, the more debt a firm uses in relation to its total assets, the greater
financial leverage its financial leverage. Financial leverage is the magnification of risk and return
The magnification of risk and
introduced through the use of fixed-cost financing, such as debt and preferred
return introduced through the use
stock. The more fixed-cost debt a firm uses, the greater will be its expected risk
of fixed-cost financing, such as
and return.
debt and preferred stock.

Patty Akers is in the process of incorporating her new business. After much
EXAMPLE
analysis she determined that an initial investment of $50,000—$20,000 in cur-
rent assets and $30,000 in fixed assets—is necessary. These funds can be
obtained in either of two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other alternative, the debt
plan, 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 be
taxed at a 40% rate. Projected balance sheets and income statements associated
with the two plans are summarized in Table 2.6. The no-debt plan results in
after-tax profits of $7,200, which represent a 14.4% rate of return on Patty’s
$50,000 investment. The debt plan results in $5,400 of after-tax profits, which
represent a 21.6% rate of return on Patty’s investment of $25,000. The debt plan
provides 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 as
well as higher potential return. Therefore, the greater the financial leverage, the
greater the potential risk and return. A detailed discussion of the impact of debt
degree of indebtedness
Measures the amount of debt on the firm’s risk, return, and value is included in Chapter 12. Here, we empha-
relative to other significant
size the use of financial debt ratios to assess externally a firm’s debt position.
balance sheet amounts.
There are two general types of debt measures: measures of the degree of
ability to service debts indebtedness and measures of the ability to service debts. The degree of indebted-
The ability of a firm to make
ness measures the amount of debt relative to other significant balance sheet
the payments required on a
amounts. A popular measure of the degree of indebtedness is the debt ratio.
scheduled basis over the life
The second type of debt measure, the ability to service debts, reflects a firm’s
of a debt.
ability to make the payments required on a scheduled basis over the life of a
coverage ratios
debt.12 The firm’s ability to pay certain fixed charges is measured using coverage
Ratios that measure the firm’s
ratios. Typically, higher coverage ratios are preferred, but too high a ratio (above
ability to pay certain fixed
industry norms) may result in unnecessarily low risk and return. In general, the
charges.



12. The term service refers to the payment of interest and repayment of principal associated with a firm’s debt obli-
gations. When a firm services its debts, it pays—or fulfills—these obligations.
54 PART 1 Introduction to Managerial Finance


TABLE 2.6 Financial Statements Associated with
Patty’s Alternatives

No-debt plan Debt plan

Balance Sheets
Current assets $20,000 $20,000
Fixed assets 30,000 30,000
Total assets $50,000 $50,000

Debt (12% interest) $ 0 $25,000
(1) Equity 50,000 25,000
Total liabilities and equity $50,000 $50,000

Income Statements

Sales $30,000 $30,000
Less: Costs and operating
expenses 18,000 18,000
Operating profits $12,000 $12,000
Less: Interest expense 0 0.12 $25,000 = 3,000
Net profit before taxes $12,000 $ 9,000
Less: Taxes (rate = 40%) 4,800 3,600
(2) Net profit after taxes $ 7,200 $ 5,400

$7,200 $5,400
Return on equity [(2) (1)] 14.4% 21.6%
$50,000 $25,000




lower the firm’s coverage ratios, the less certain it is to be able to pay fixed obli-
gations. If a firm is unable to pay these obligations, its creditors may seek imme-
diate repayment, which in most instances would force a firm into bankruptcy.
Two popular coverage ratios are the times interest earned ratio and the fixed-
payment coverage ratio.


Debt Ratio
The debt ratio measures the proportion of total assets financed by the firm’s cred-
debt ratio
Measures the proportion of total itors. The higher this ratio, the greater the amount of other people’s money being
assets financed by the firm’s used to generate profits. The ratio is calculated as follows:
creditors.
Total liabilities
Debt ratio
Total assets
The debt ratio for Bartlett Company in 2003 is
$1,643,000
0.457 45.7%
$3,597,000
This value indicates that the company has financed close to half of its assets with
debt. The higher this ratio, the greater the firm’s degree of indebtedness and the
more financial leverage it has.
55
CHAPTER 2 Financial Statements and Analysis


Times Interest Earned Ratio
The times interest earned ratio, sometimes called the interest coverage ratio, mea-
times interest earned ratio
Measures the firm’s ability to sures the firm’s ability to make contractual interest payments. The higher its
make contractual interest
value, the better able the firm is to fulfill its interest obligations. The times inter-
payments; sometimes called the
est earned ratio is calculated as follows:
interest coverage ratio.
Earnings before interest and taxes
Times interest earned ratio
Interest
The figure for earnings before interest and taxes is the same as that for operating
profits shown in the income statement. Applying this ratio to Bartlett Company
yields the following 2003 value:
$418,000
Times interest earned ratio 4.5
$93,000
The times interest earned ratio for Bartlett Company seems acceptable. A value
of at least 3.0—and preferably closer to 5.0—is often suggested. The firm’s
earnings 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 interest
it owes. Thus it has a good margin of safety.


Fixed-Payment Coverage Ratio
The fixed-payment coverage ratio measures the firm’s ability to meet all fixed-
fixed-payment coverage ratio
payment obligations, such as loan interest and principal, lease payments, and pre-
Measures the firm’s ability to
meet all fixed-payment ferred stock dividends.13 As is true of the times interest earned ratio, the higher
obligations.
this value, the better. The formula for the fixed-payment coverage ratio is
Fixed- Earnings before interest and taxes Lease payments
payment
Interest Lease payments
coverage
{(Principal payments Preferred stock dividends) [1/(1 T)]}
ratio
where T is the corporate tax rate applicable to the firm’s income. The term
1/(1 T) is included to adjust the after-tax principal and preferred stock divi-
dend payments back to a before-tax equivalent that is consistent with the before-
tax values of all other terms. Applying the formula to Bartlett Company’s 2003
data yields
Fixed-payment $418,000 $35,000
coverage ratio $93,000 $35,000 {($71,000 $10,000) [1/(1 0.29)]}
$453,000
1.9
$242,000
Because the earnings available are nearly twice as large as its fixed-payment
obligations, the firm appears safely able to meet the latter.
Like the times interest earned ratio, the fixed-payment coverage ratio mea-
sures risk. The lower the ratio, the greater the risk to both lenders and owners;


13. Although preferred stock dividends, which are stated at the time of issue, can be “passed” (not paid) at the
option of the firm’s directors, it is generally believed that the payment of such dividends is necessary. This text there-
fore treats the preferred stock dividend as a contractual obligation, to be paid as a fixed amount, as scheduled.
56 PART 1 Introduction to Managerial Finance


the greater the ratio, the lower the risk. This ratio allows interested parties to
assess the firm’s ability to meet additional fixed-payment obligations without
being driven into bankruptcy.


Review Questions

2–9 What is financial leverage?
2–10 What ratio measures the firm’s degree of indebtedness? What ratios
assesses the firm’s ability to service debts?



Profitability Ratios
LG5

There are many measures of profitability. As a group, these measures enable the
analyst to evaluate the firm’s profits with respect to a given level of sales, a cer-
tain level of assets, or the owners’ investment. Without profits, a firm could not
attract outside capital. Owners, creditors, and management pay close attention to
boosting profits because of the great importance placed on earnings in the
marketplace.


Common-Size Income Statements
A popular tool for evaluating profitability in relation to sales is the common-size
common-size income statement
An income statement in which income statement. Each item on this statement is expressed as a percentage of
each item is expressed as a sales. Common-size income statements are especially useful in comparing perfor-
percentage of sales.
mance across years. Three frequently cited ratios of profitability that can be read
directly 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 Company
are presented and evaluated in Table 2.7. These statements reveal that the firm’s
cost of goods sold increased from 66.7 percent of sales in 2002 to 67.9 percent in
2003, resulting in a worsening gross profit margin. However, thanks to a
decrease in total operating expenses, the firm’s net profit margin rose from 5.4
percent of sales in 2002 to 7.2 percent in 2003. The decrease in expenses more
than compensated for the increase in the cost of goods sold. A decrease in the
firm’s 2003 interest expense (3.0 percent of sales versus 3.5 percent in 2002)
added to the increase in 2003 profits.


Gross Profit Margin
The gross profit margin measures the percentage of each sales dollar remaining
gross profit margin
Measures the percentage of each after the firm has paid for its goods. The higher the gross profit margin, the better
sales dollar remaining after the
(that is, the lower the relative cost of merchandise sold). The gross profit margin
firm has paid for its goods.
is calculated as follows:
Sales Cost of goods sold Gross profits
Gross profit margin
Sales Sales
57
CHAPTER 2 Financial Statements and Analysis


TABLE 2.7 Bartlett Company Common-Size Income
Statements

For the years ended
Evaluationa
December 31

2003 2002 2002–2003

Sales revenue 100.0% 100.0% same
Less: Cost of goods sold 67.9 66.7 worse
(1) Gross profit margin 32.1% 33.3% worse
Less: Operating expenses
Selling expense 3.3% 4.2% better
General and administrative expenses 6.8 6.7 better
Lease expense 1.1 1.3 better
Depreciation expense 7.3 9.3 better
Total operating expense 18.5% 21.5% better
(2) Operating profit margin 13.6% 11.8% better
Less: Interest expense 3.0 3.5 better
Net profits before taxes 10.6% 8.3% better
worseb
Less: Taxes 3.1 2.5
Net profits after taxes 7.5% 5.8% better
Less: Preferred stock dividends 0.3 0.4 better
(3) Net profit margin 7.2% 5.4% better

aSubjectiveassessments based on data provided.
bTaxes as a percent of sales increased noticeably between 2002 and 2003 because of differing costs and
expenses, whereas the average tax rates (taxes net profits before taxes) for 2002 and 2003 remained
about the same—30% and 29%, respectively.




Bartlett Company’s gross profit margin for 2003 is
$3,074,000 $2,088,000 $986,000
32.1%
$3,074,000 $3,074,000
This value is labeled (1) on the common-size income statement in Table 2.7.


Operating Profit Margin
The operating profit margin measures the percentage of each sales dollar remain-
operating profit margin
Measures the percentage of each ing after all costs and expenses other than interest, taxes, and preferred stock div-
sales dollar remaining after all
idends are deducted. It represents the “pure profits” earned on each sales dollar.
costs and expenses other than
Operating profits are “pure” because they measure only the profits earned on
interest, taxes, and preferred
operations and ignore interest, taxes, and preferred stock dividends. A high oper-
stock dividends are deducted;
ating profit margin is preferred. The operating profit margin is calculated as
the “pure profits” earned on each
sales dollar. follows:
Operating profits
Operating profit margin
Sales
58 PART 1 Introduction to Managerial Finance


Bartlett Company’s operating profit margin for 2003 is

$418,000
13.6%
$3,074,000

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