<<

ńňđ. 2
(âńĺăî 3)

ŃÎÄĹĐĆŔÍČĹ

>>

This value is labeled (2) on the common-size income statement in Table 2.7.



Net Profit Margin
The net profit margin measures the percentage of each sales dollar remaining
net profit margin
after all costs and expenses, including interest, taxes, and preferred stock divi-
Measures the percentage of each
sales dollar remaining after all dends, have been deducted. The higher the firm’s net profit margin, the better.
costs and expenses, including
The net profit margin is calculated as follows:
interest, taxes, and preferred
stock dividends, have been
Earnings available for common stockholders
deducted.
Net profit margin
Sales

Bartlett Company’s net profit margin for 2003 is

$221,000
7.2%
$3,074,000

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 firm’s success with
respect to earnings on sales. “Good” net profit margins differ considerably across
industries. A net profit margin of 1 percent or less would not be unusual for a
grocery store, whereas a net profit margin of 10 percent would be low for a retail
jewelry store.



Earnings per Share (EPS)
The firm’s earnings per share (EPS) is generally of interest to present or prospec-
tive stockholders and management. As we noted earlier, EPS represents the num-
ber of dollars earned during the period on behalf of each outstanding share of
common stock. Earnings per share is calculated as follows:

Earnings available for common stockholders
Earnings per share
Number of shares of common stock outstanding

Bartlett Company’s earnings per share in 2003 is

$221,000
$2.90
76,262

This figure represents the dollar amount earned on behalf of each share. The
dollar amount of cash actually distributed to each shareholder is the dividend
per share (DPS), which as noted Bartlett Company’s income statement
(Table 2.1), rose to $1.29 in 2003 from $0.75 in 2002. EPS is closely watched
59
CHAPTER 2 Financial Statements and Analysis


by the investing public and is considered an important indicator of corporate
success.


Return on Total Assets (ROA)
The return on total assets (ROA), often called the return on investment (ROI),
return on total assets (ROA)
measures the overall effectiveness of management in generating profits with its
Measures the overall effective-
ness of management in generat- available assets. The higher the firm’s return on total assets, the better. The return
ing profits with its available
on total assets is calculated as follows:
assets; also called the return on
investment (ROI).
Earnings available for common stockholders
Return on total assets
Total assets

Bartlett Company’s return on total assets in 2003 is

$221,000
6.1%
$3,597,000

This value indicates that the firm earned 6.1 cents on each dollar of asset
investment.


Return on Common Equity (ROE)
The return on common equity (ROE) measures the return earned on the common
return on common equity (ROE)
stockholders’ investment in the firm. Generally, the higher this return, the better
Measures the return earned on
the common stockholders’ off are the owners. Return on common equity is calculated as follows:
investment in the firm.
Earnings available for common stockholders
Return on common equity
Common stock equity

This ratio for Bartlett Company in 2003 is

$221,000
12.6%
$1,754,000

Note that the value for common stock equity ($1,754,000) was found by sub-
tracting the $200,000 of preferred stock equity from the total stockholders’
equity of $1,954,000 (see Bartlett Company’s 2003 balance sheet in Table 2.2).
The calculated ROE of 12.6 percent indicates that during 2003 Bartlett earned
12.6 cents on each dollar of common stock equity.


Review Questions

2–11 What three ratios of profitability are found on a common-size income
statement?
2–12 What would explain a firm’s having a high gross profit margin and a low
net profit margin?
2–13 Which measure of profitability is probably of greatest interest to the
investing public? Why?
60 PART 1 Introduction to Managerial Finance


Market Ratios
LG5


Market ratios relate the firm’s market value, as measured by its current share
market ratios
Relate a firm’s market value, as price, to certain accounting values. These ratios give insight into how well
measured by its current share
investors in the marketplace feel the firm is doing in terms of risk and return.
price, to certain accounting
They tend to reflect, on a relative basis, the common stockholders’ assessment of
values.
all aspects of the firm’s past and expected future performance. Here we consider
two popular market ratios, one that focuses on earnings and another that consid-
ers book value.


Price/Earnings (P/E) Ratio
The price/earnings (P/E) ratio measures the amount that investors are willing to
price/earnings (P/E) ratio
Measures the amount that pay for each dollar of a firm’s earnings. The level of the price/earnings ratio indi-
investors are willing to pay for
cates the degree of confidence that investors have in the firm’s future perfor-
each dollar of a firm’s earnings;
mance. The higher the P/E ratio, the greater is investor confidence. The P/E ratio
the higher the P/E ratio, the
is calculated as follows:
greater is investor confidence.

Market price per share of common stock
Price/earnings (P/E) ratio
Earnings per share

If Bartlett Company’s 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
11.1
$2.90

This 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 analysis using
an industry average P/E ratio or the P/E ratio of a benchmark firm.


Market/Book (M/B) Ratio
The market/book (M/B) ratio provides an assessment of how investors view the
market/book (M/B) ratio
Provides an assessment of how firm’s performance. It relates the market value of the firm’s shares to their
investors view the firm’s perfor- book—strict accounting—value. To calculate the firm’s M/B ratio, we first need
mance. Firms expected to earn
to find the book value per share of common stock:
high returns relative to their risk
typically sell at higher M/B
Book value per Common stock equity
multiples.
share of common stock Number of shares of common stock outstanding

Substituting the appropriate values for Bartlett Company from its 2003 balance
sheet, we get

$1,754,000
Book value per share of common stock $23.00
76,262

The formula for the market/book ratio is

Market price per share of common stock
Market/book (M/B) ratio
Book value per share of common stock
61
CHAPTER 2 Financial Statements and Analysis


Substituting Bartlett Company’s end of 2003 common stock price of $32.25 and
its $23.00 book value per share of common stock (calculated above) into the M/B
ratio formula, we get

$32.25
Market/book (M/B) ratio 1.40
$23.00

This M/B ratio means that investors are currently paying $1.40 for each $1.00 of
book value of Bartlett Company’s stock.
The stocks of firms that are expected to perform well—improve profits,
increase their market share, or launch successful products—typically sell at
higher M/B ratios than the stocks of firms with less attractive outlooks. Simply
stated, firms expected to earn high returns relative to their risk typically sell at
higher M/B multiples. Clearly, Bartlett’s future prospects are being viewed favor-
ably by investors, who are willing to pay more than its book value for the firm’s
shares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally, to get a
feel for the firm’s risk and return compared to peer firms.



Review Question

2–14 How do the price/earnings (P/E) ratio and the market/book (M/B) ratio
provide a feel for the firm’s risk and return?



A Complete Ratio Analysis
LG6

Analysts frequently wish to take an overall look at the firm’s financial perfor-
mance and status. Here we consider two popular approaches to a complete ratio
analysis: (1) summarizing all ratios and (2) the DuPont system of analysis. The
summary analysis approach tends to view all aspects of the firm’s financial activ-
ities to isolate key areas of responsibility. The DuPont system acts as a search
technique aimed at finding the key areas responsible for the firm’s financial
condition.


Summarizing All Ratios
We can use Bartlett Company’s ratios to perform a complete ratio analysis using
both cross-sectional and time-series analysis approaches. The 2003 ratio values
calculated earlier and the ratio values calculated for 2001 and 2002 for Bartlett
Company, along with the industry average ratios for 2003, are summarized in
Table 2.8, which also shows the formula used to calculate each ratio. Using these
data, we can discuss the five key aspects of Bartlett’s performance—liquidity,
activity, debt, profitability, and market.

Liquidity
The overall liquidity of the firm seems to exhibit a reasonably stable trend, hav-
ing been maintained at a level that is relatively consistent with the industry aver-
age in 2003. The firm’s liquidity seems to be good.
62
Summary of Bartlett Company Ratios (2001–2003, Including 2003 Industry Averages)
TABLE 2.8

Evaluationd

Industry Cross- Time-
Year
average sectional series
Ratio Formula 2001a 2002b 2003b 2003c 2003 2001–2003 Overall

Liquidity

Current assets
Current ratio 2.04 2.08 1.97 2.05 OK OK OK
Current liabilities
Current assets Inventory
Quick (acid-test) ratio 1.32 1.46 1.51 1.43 OK good
Current liabilities
good


Activity

Cost of goods sold
Inventory turnover 5.1 5.7 7.2 6.6 good good good
Inventory
Accounts receivable
Average collection period 43.9 days 51.2 days 58.9 days 44.3 days poor poor
Average sales per day
poor
Accounts payable
Average payment period 75.8 days 81.2 days 94.1 days 66.5 days poor poor poor
Average purchases per day
Sales
Total asset turnover 0.94 0.79 0.85 0.75 OK OK
Total assets
OK


Debt

Total liabilities
Debt ratio 36.8% 44.3% 45.7% 40.0% OK OK OK
Total assets
Earnings before interest and taxes
Times interest earned ratio 5.6 3.3 4.5 4.3 good OK OK
Interest
Earnings before interest and taxes Lease payments
Fixed-payment coverage ratio 2.4 1.4
Int. Lease pay. {(Prin. Pref. div.) [1/(1 T )]}
1.9 1.5 good
OK good
Evaluationd

Industry Cross- Time-
Year
average sectional series
Ratio Formula 2001a 2002b 2003b 2003c 2003 2001–2003 Overall

Profitability

Gross profits
Gross profit margin 31.4% 33.3% 32.1% 30.0% OK OK OK
Sales
Operating profits
Operating profit margin 14.6% 11.8% 13.6% 11.0% good OK
Sales
good
Earnings available for common stockholders
Net profit margin 8.2% 5.4% 7.2% 6.2% good OK good
Sales
Earnings available for common stockholders
Earnings per share (EPS) $3.26 $1.81
Number of shares of common stock outstanding
$2.90 $2.26 good
OK good
Earnings available for common stockholders
Return on total assets 7.8% 4.2% 6.1% 4.6% good OK good
Total assets
(ROA)
Earnings available for common stockholders
Return on common equity 13.7% 8.5% 12.6% 8.5%
Common stock equity
(ROE)
good OK
good


Market

Market price per share of common stock
Price/earnings (P/E) ratio 10.5 10.0e 11.1 12.5 OK OK OK
Earnings per share
Market price per share of common stock
Market/book (M/B) ratio 1.25 0.85e
Book value per share of common stock
1.40 1.30 OK
OK OK

aCalculated from data not included in the chapter.
bCalculated by using the financial statements presented in Tables 2.1 and 2.2.




63
64 PART 1 Introduction to Managerial Finance


Activity
Bartlett Company’s inventory appears to be in good shape. Its inventory man-
agement seems to have improved, and in 2003 it performed at a level above
that of the industry. The firm may be experiencing some problems with
accounts receivable. The average collection period seems to have crept up above
that of the industry. Bartlett also appears to be slow in paying its bills; it pays
nearly 30 days slower than the industry average. This could adversely affect the
firm’s credit standing. Although overall liquidity appears to be good, the man-
agement of receivables and payables should be examined. Bartlett’s total asset
turnover reflects a decline in the efficiency of total asset utilization between
2001 and 2002. 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.

Debt
Bartlett Company’s indebtedness increased over the 2001–2003 period and is
currently above the industry average. Although this increase in the debt ratio
could be cause for alarm, the firm’s ability to meet interest and fixed-payment
obligations improved, from 2002 to 2003, to a level that outperforms the indus-
try. The firm’s increased indebtedness in 2002 apparently caused a deterioration
in its ability to pay debt adequately. However, Bartlett has evidently improved its
income in 2003 so that it is able to meet its interest and fixed-payment obliga-
tions at a level consistent with the average in the industry. In summary, it appears
that although 2002 was an off year, the company’s ability to pay debts in 2003
compensates for its increased degree of indebtedness.

Profitability
Bartlett’s profitability relative to sales in 2003 was better than the average com-
pany in the industry, although it did not match the firm’s 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 have
caused the 2003 net profit margin to fall below that of 2001. However, Bartlett
Company’s 2003 net profit margin is quite favorable when compared to the
industry average.
The firm’s earnings per share, return on total assets, and return on common
equity behaved much as its net profit margin did over the 2001–2003 period.
Bartlett appears to have experienced either a sizable drop in sales between 2001
and 2002 or a rapid expansion in assets during that period. The exceptionally
high 2003 level of return on common equity suggests that the firm is performing
quite well. The firm’s above-average returns—net profit margin, EPS, ROA, and
ROE—may be attributable to the fact that it is more risky than average. A look at
market ratios is helpful in assessing risk.

Market
Investors 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 below
the industry average. The P/E ratio suggests that the firm’s risk has declined but
65
CHAPTER 2 Financial Statements and Analysis


remains above that of the average firm in its industry. The firm’s market/book
(M/B) ratio has increased over the 2001–2003 period, and in 2003 it exceeds the
industry average. This implies that investors are optimistic about the firm’s future
performance. The P/E and M/B ratios reflect the firm’s increased profitability
over the 2001–2003 period: Investors expect to earn high future returns as com-
pensation for the firm’s above-average risk.

In summary, the firm appears to be growing and has recently undergone an
expansion in assets, financed primarily through the use of debt. The 2002–2003
period seems to reflect a phase of adjustment and recovery from the rapid growth
in assets. Bartlett’s sales, profits, and other performance factors seem to be grow-
ing with the increase in the size of the operation. In addition, the market response
to these accomplishments appears to have been positive. In short, the firm seems
to have done well in 2003.



DuPont System of Analysis
The DuPont system of analysis is used to dissect the firm’s financial statements
DuPont system of analysis
System used to dissect the firm’s and to assess its financial condition. It merges the income statement and balance
financial statements and to
sheet into two summary measures of profitability: return on total assets (ROA)
assess its financial condition.
and return on common equity (ROE). Figure 2.2 depicts the basic DuPont system
with Bartlett Company’s 2003 monetary and ratio values. The upper portion of
the chart summarizes the income statement activities; the lower portion summa-
rizes the balance sheet activities.
The DuPont system first brings together the net profit margin, which measures
the firm’s profitability on sales, with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales. In the DuPont formula, the
DuPont formula
product of these two ratios results in the return on total assets (ROA):
Multiplies the firm’s net profit
margin by its total asset turnover
ROA Net profit margin Total asset turnover
to calculate the firm’s return on
total assets (ROA).
Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
Earnings available for Earnings available for
common stockholders Sales common stockholders
ROA
Sales Total assets Total assets
When the 2003 values of the net profit margin and total asset turnover for
Bartlett Company, calculated earlier, are substituted into the DuPont formula, the
result is
ROA 7.2% 0.85 6.1%
This value is the same as that calculated directly in an earlier section (page 59).
The DuPont formula enables the firm to break down its return into profit-on-
sales and efficiency-of-asset-use components. Typically, a firm with a low net
modified DuPont formula profit margin has a high total asset turnover, which results in a reasonably good
Relates the firm’s return on total
return on total assets. Often, the opposite situation exists.
assets (ROA) to its return on
The second step in the DuPont system employs the modified DuPont formula.
common equity (ROE) using the
This formula relates the firm’s return on total assets (ROA) to its return on com-
financial leverage multiplier
mon equity (ROE). The latter is calculated by multiplying the return on total
(FLM).
66 PART 1 Introduction to Managerial Finance


FIGURE 2.2 DuPont System of Analysis
The DuPont system of analysis with application to Bartlett Company (2003)


Sales
$3,074,000

minus
Cost of
Earnings
Goods Sold
Available
$2,088,000
for Common
Stockholders
minus
Statement




$221,000
Income




Operating Net Profit
Expenses Margin
divided by
$568,000 7.2%
Sales
minus
$3,074,000
Interest
Expense
$93,000
minus

Return on
Taxes
Total Assets
multiplied
$94,000 by (ROA)
6.1%
minus
Preferred Stock
Dividends
$10,000

Sales
$3,074,000
Current Total Asset
Assets Turnover
divided by
$1,223,000 0.85
Total Assets Return on
plus
$3,597,000 Common
multiplied
Net Fixed Equity (ROE)
by
Assets 12.6%
$2,374,000
Balance
Sheet




Current
Liabilities
$620,000
Total
Liabilities
plus
Total Liabilities
$1,643,000
Long-Term and Stockholders’
Debt Equity = Total
plus
$1,023,000 Assets
Stockholders’ Financial
$3,597,000
Equity Leverage
$1,954,000 Multiplier (FLM)
divided by
2.06
Common Stock
Equity
$1,754,000
67
CHAPTER 2 Financial Statements and Analysis


assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of
financial leverage multiplier
total assets to common stock equity:
(FLM)
The ratio of the firm’s total assets
ROE ROA FLM
to its common stock equity.

Substituting the appropriate formulas into the equation and simplifying results in
the formula given earlier,
Earnings available for Earnings available for
common stockholders Total assets common stockholders
ROE
Total assets Common stock Common stock
equity equity
Use of the financial leverage multiplier (FLM) to convert the ROA into the
ROE reflects the impact of financial leverage on owners’ return. Substituting the
values for Bartlett Company’s ROA of 6.1 percent, calculated earlier, and
Bartlett’s FLM of 2.06 ($3,597,000 total assets $1,754,000 common stock
equity) into the modified DuPont formula yields
ROE 6.1% 2.06 12.6%
The 12.6 percent ROE calculated by using the modified DuPont formula is the
same as that calculated directly (page 59).
The advantage of the DuPont system is that it allows the firm to break its return
on equity into a profit-on-sales component (net profit margin), an efficiency-of-
asset-use component (total asset turnover), and a use-of-financial-leverage compo-
nent (financial leverage multiplier). The total return to owners therefore can be
analyzed in these important dimensions.
The use of the DuPont system of analysis as a diagnostic tool is best ex-
plained using Figure 2.2. Beginning with the rightmost value—the ROE—the
financial analyst moves to the left, dissecting and analyzing the inputs to the for-
mula in order to isolate the probable cause of the resulting above-average (or
below-average) value. For the sake of discussion, let’s assume that Bartlett’s ROE
of 12.6 percent is actually below the industry average. Moving to the left, we
would examine the inputs to the ROE—the ROA and the FLM—relative to the
industry averages. Let’s 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 exam-
ine the two inputs to the ROA—the net profit margin and total asset turnover.
Assume that the net profit margin is in line with the industry average, but the
total asset turnover is below the industry average. Moving still farther to the left,
we find that whereas the firm’s sales are consistent with the industry value,
Bartlett’s total assets have grown significantly during the past year. Looking far-
ther to the left, we would review the firm’s activity ratios for current assets. Let’s
say that whereas the firm’s 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: Bartlett’s low
ROE is primarily the consequence of slow collections of accounts receivable,
which resulted in high levels of receivables and therefore high levels of total
assets. The high total assets slowed Bartlett’s total asset turnover, driving down
its ROA, which then drove down its ROE. By using the DuPont system of analy-
sis to dissect Bartlett’s overall returns as measured by its ROE, we found that
slow collections of receivables caused the below-industry-average ROE. Clearly,
the firm needs to manage its credit operations better.
68 PART 1 Introduction to Managerial Finance


Review Questions

2–15 Financial ratio analysis is often divided into five areas: liquidity, activity,
debt, profitability, and market ratios. Differentiate each of these areas of
analysis from the others. Which is of the greatest concern to creditors?
2–16 Describe how you would use a large number of ratios to perform a com-
plete ratio analysis of the firm.
2–17 What three areas of analysis are combined in the modified DuPont for-
mula? Explain how the DuPont system of analysis is used to dissect the
firm’s results and isolate their causes.




SUMMARY
FOCUS ON VALUE
Financial managers review and analyze the firm’s financial statements periodically, both to
uncover developing problems and to assess the firm’s progress toward achieving its goals.
These actions are aimed at preserving and creating value for the firm’s owners. Financial
ratios enable financial managers to monitor the pulse of the firm and its progress toward its
strategic 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) that
affect share price, which management is attempting to maximize.




REVIEW OF LEARNING GOALS
Review the contents of the stockholders’ re- Understand who uses financial ratios, and how.
LG1 LG2
port and the procedures for consolidating in- Ratio analysis enables present and prospective
ternational financial statements. The annual stock- stockholders and lenders and the firm’s manage-
holders’ report, which publicly owned corporations ment to evaluate the firm’s financial performance. It
are required to provide to stockholders, documents can be performed on a cross-sectional or a time-
the firm’s financial activities during the past year. series basis. Benchmarking is a popular type of
It includes the letter to stockholders and various cross-sectional analysis. Key cautions for applying
subjective and factual information, as well as four financial ratios are: (1) Ratios with large deviations
key financial statements: the income statement, the from the norm only indicate symptoms of a prob-
balance sheet, the statement of retained earnings, lem. (2) A single ratio does not generally provide
and the statement of cash flows. Notes describing sufficient information. (3) The ratios being com-
the technical aspects of the financial statements fol- pared should be calculated using financial state-
low them. Financial statements of companies that ments dated at the same point in time during the
have operations whose cash flows are denominated year. (4) Audited financial statements should be
in one or more foreign currencies must be trans- used. (5) Data should be checked for consistency of
lated into dollars in accordance with FASB accounting treatment. (6) Inflation and different as-
Standard No. 52. set ages can distort ratio comparisons.
69
CHAPTER 2 Financial Statements and Analysis


Use ratios to analyze a firm’s liquidity and ac- Use ratios to analyze a firm’s profitability and its
LG3 LG5
tivity. Liquidity, or ability of the firm to pay market value. The common-size income state-
its bills as they come due, can be measured by the ment, which shows all items as a percentage of sales,
current ratio and the quick (acid-test) ratio. Activ- can be used to determine gross profit margin, operat-
ity ratios measure the speed with which accounts ing profit margin, and net profit margin. Other mea-
are converted into sales or cash—inflows or out- sures of profitability include earnings per share, re-
flows. The activity of inventory can be measured turn on total assets, and return on common equity.
by its turnover, that of accounts receivable by the Market ratios include the price/earnings ratio and
average collection period, and that of accounts the market/book ratio. Formulas for these profitabil-
payable by the average payment period. Total asset ity and market ratios are summarized in Table 2.8.
turnover measures the efficiency with which the
firm uses its assets to generate sales. Formulas for Use a summary of financial ratios and the
LG6
these liquidity and activity ratios are summarized DuPont system of analysis to perform a com-
in Table 2.8. plete ratio analysis. A summary of all ratios—liquid-
ity, activity, debt, profitability, and market—as
Discuss the relationship between debt and fi- shown in Table 2.8 can be used to perform a com-
LG4
nancial leverage and the ratios used to analyze plete ratio analysis using cross-sectional and time-
a firm’s debt. The more debt a firm uses, the greater series analysis approaches. The DuPont system of
its financial leverage, which magnifies both risk and analysis, summarized in Figure 2.2, is a diagnostic
return. Financial debt ratios measure both the de- tool used to find the key areas responsible for the
gree of indebtedness and the ability to service debts. firm’s financial performance. It enables the firm to
A common measure of indebtedness is the debt ra- break the return on common equity into three com-
tio. The ability to pay fixed charges can be mea- ponents: profit on sales, efficiency of asset use, and
sured by times interest earned and fixed-payment use of leverage. The DuPont system of analysis
coverage ratios. Formulas for these debt ratios are makes it possible to assess all aspects of the firm’s ac-
summarized in Table 2.8. tivities in order to isolate key areas of responsibility.



SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 2–1 Ratio formulas and interpretations Without referring to the text, indicate for
LG3 LG4 LG5
each of the following ratios the formula for calculating it and the kinds of prob-
lems, if any, the firm is likely to have if that ratio is too high relative to the
industry average. What if the ratio is too low relative to the industry? Create a
table similar to the one that follows and fill in the empty blocks.

Ratio Too high Too low

Current ratio

Inventory turnover

Times interest earned

Gross profit margin

Return on total assets


ST 2–2 Balance sheet completion using ratios Complete the 2003 balance sheet for
LG3 LG4 LG5
O’Keefe Industries using the information that follows it.
70 PART 1 Introduction to Managerial Finance


O’Keefe Industries
Balance Sheet
December 31, 2003

Assets Liabilities and Stockholders’ Equity

Cash $30,000 Accounts payable $120,000
Marketable securities 25,000 Notes payable
Accounts receivable Accruals 20,000
Inventories Total current liabilities
Total current assets Long-term debt
Net fixed assets Stockholders’ equity $600,000
Total assets $ Total liabilities and
stockholders’ equity $



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 period
was 40 days.


PROBLEMS
2–1 Reviewing basic financial statements The income statement for the year ended
LG1
December 31, 2003, the balance sheets for December 31, 2003 and 2002, and
the statement of retained earnings for the year ended December 31, 2003, for
Technica, Inc., are given here. Briefly discuss the form and informational content
of each of these statements.


Technica, Inc.
Income Statement
for the Year Ended December 31, 2003

Sales revenue $600,000
Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expense $30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Earnings available for common stockholders $ 42,900

Earnings per share (EPS) $2.15
71
CHAPTER 2 Financial Statements and Analysis


Technica, Inc.
Balance Sheets

December 31
Assets 2003 2002

Cash $ 15,000 $ 16,000
Marketable securities 7,200 8,000
Accounts receivable 34,100 42,200
Inventories 82,000 50,000
Total current assets $138,300 $116,200
Land and buildings $150,000 $150,000
Machinery and equipment 200,000 190,000
Furniture and fixtures 54,000 50,000
Other 11,000 10,000
Total gross fixed assets $415,000 $400,000
Less: Accumulated depreciation 145,000 115,000
Net fixed assets $270,000 $285,000
Total assets $408,300 $401,200

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000 $ 49,000
Notes payable 13,000 16,000
Accruals 5,000 6,000
Total current liabilities $ 75,000 $ 71,000
Long-term debt $150,000 $160,000
Stockholders’ equity
Common stock equity (shares
outstanding: 19,500 in 2003 and
20,000 in 2002) $110,200 $120,000
Retained earnings 73,100 50,200
Total stockholders’ equity $183,300 $170,200
Total liabilities and stockholders’ equity $408,300 $401,200




Technica, Inc.
Statement of Retained Earnings
for the Year Ended December 31, 2003

Retained earnings balance (January 1, 2003) $50,200
Plus: Net profits after taxes (for 2003) 42,900
Less: Cash dividends (paid during 2003) ( 20,000)
Retained earnings balance (December 31, 2003) $73,100



2–2 Financial statement account identification Mark each of the accounts listed in
LG1
the following table as follows:
72 PART 1 Introduction to Managerial Finance


a. In column (1), indicate in which statement—income statement (IS) or balance
sheet (BS)—the account belongs.
b. In column (2), indicate whether the account is a current asset (CA), current
liability (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue
(R), or stockholders’ equity (SE).


(1) (2)
Account name Statement Type of account

Accounts payable
Accounts receivable
Accruals
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debts
Machinery
Marketable securities
Notes payable
Operating expense
Paid-in capital in excess of par
Preferred stock
Preferred stock dividends
Retained earnings
Sales revenue
Selling expense
Taxes
Vehicles




2–3 Income statement preparation On December 31, 2003, Cathy Chen, a self-
LG1
employed certified public accountant (CPA), completed her first full year in busi-
ness. During the year, she billed $180,000 for her accounting services. She had
two employees: a bookkeeper and a clerical assistant. In addition to her monthly
salary of $4,000, Ms. Chen paid annual salaries of $24,000 and $18,000 to the
bookkeeper and the clerical assistant, respectively. Employment taxes and benefit
costs for Ms. Chen and her employees totaled $17,300 for the year. Expenses for
office supplies, including postage, totaled $5,200 for the year. In addition, Ms.
Chen spent $8,500 during the year on tax-deductible travel and entertainment
73
CHAPTER 2 Financial Statements and Analysis


associated with client visits and new business development. Lease payments for
the office space rented (a tax-deductible expense) were $1,350 per month. Depre-
ciation expense on the office furniture and fixtures was $7,800 for the year. Dur-
ing the year, Ms. Chen paid interest of $7,500 on the $60,000 borrowed to start
the business. She paid an average tax rate of 30 percent during 2003.
a. Prepare an income statement for Cathy Chen, CPA, for the year ended
December 31, 2003.
b. Evaluate her 2003 financial performance.


2–4 Calculation of EPS and retained earnings Philagem, Inc., ended 2003 with net
LG1
profit before taxes of $218,000. The company is subject to a 40% tax rate and
must pay $32,000 in preferred stock dividends before distributing any earnings
on the 85,000 shares of common stock currently outstanding.
a. Calculate Philagem’s 2003 earnings per share (EPS).
b. If the firm paid common stock dividends of $0.80 per share, how many dol-
lars would go to retained earnings?


2–5 Balance sheet preparation Use the appropriate items from the following list to
LG1
prepare in good form Owen Davis Company’s balance sheet at December 31,
2003.


Value ($000) at
Item December 31, 2003

Accounts payable $ 220
Accounts receivable 450
Accruals 55
Accumulated depreciation 265
Buildings 225
Cash 215
Common stock (at par) 90
Cost of goods sold 2,500
Depreciation expense 45
Equipment 140
Furniture and fixtures 170
General expense 320
Inventories 375
Land 100
Long-term debts 420
Machinery 420
Marketable securities 75
Notes payable 475
Paid-in capital in excess of par 360
Preferred stock 100
Retained earnings 210
Sales revenue 3,600
Vehicles 25
74 PART 1 Introduction to Managerial Finance


2–6 Initial sale price of common stock Beck Corporation has one issue of preferred
LG1
stock and one issue of common stock outstanding. Given Beck’s stockholders’
equity account that follows, determine the original price per share at which the
firm sold its single issue of common stock.


Stockholders’ Equity ($000)

Preferred stock $ 125
Common stock ($0.75 par, 300,000 shares outstanding) 225
Paid-in capital in excess of par on common stock 2,625
Retained earnings 900
Total stockholders’ equity $3,875



2–7 Statement of retained earnings Hayes Enterprises began 2003 with a retained
LG1
earnings balance of $928,000. During 2003, the firm earned $377,000 after
taxes. From this amount, preferred stockholders were paid $47,000 in divi-
dends. At year-end 2003, the firm’s retained earnings totaled $1,048,000. The
firm had 140,000 shares of common stock outstanding during 2003.
a. Prepare a statement of retained earnings for the year ended December 31,
2003, for Hayes Enterprises. (Note: Be sure to calculate and include the
amount of cash dividends paid in 2003.)
b. Calculate the firm’s 2003 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock dur-
ing 2003?

2–8 Ratio comparisons Robert Arias recently inherited a stock portfolio from his
LG5
LG2 LG3 LG4
uncle. 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 to
each other. Some of his ratios are listed below.


Island Burger Fink Roland
Ratio Electric Utility Heaven Software Motors

Current ratio 1.10 1.3 6.8 4.5
Quick ratio 0.90 0.82 5.2 3.7
Debt ratio 0.68 0.46 0 0.35
Net profit margin 6.2% 14.3% 28.5% 8.4%



Assuming that his uncle was a wise investor who assembled the portfolio
with care, Robert finds the wide differences in these ratios confusing. Help
him out.
a. What problems might Robert encounter in comparing these companies to
one another on the basis of their ratios?
b. Why might the current and quick ratios for the electric utility and the
fast-food stock be so much lower than the same ratios for the other
companies?
75
CHAPTER 2 Financial Statements and Analysis


c. Why might it be all right for the electric utility to carry a large amount of
debt, but not the software company?
d. Why wouldn’t investors invest all of their money in software companies
instead of in less profitable companies? (Focus on risk and return.)

2–9 Liquidity management Bauman Company’s total current assets, total current
LG3
liabilities, and inventory for each of the past 4 years follow:


Item 2000 2001 2002 2003

Total current assets $16,950 $21,900 $22,500 $27,000
Total current liabilities 9,000 12,600 12,600 17,400
Inventory 6,000 6,900 6,900 7,200



a. Calculate the firm’s current and quick ratios for each year. Compare the
resulting time series for these measures of liquidity.
b. Comment on the firm’s liquidity over the 2000–2003 period.
c. If you were told that Bauman Company’s inventory turnover for each
year in the 2000–2003 period and the industry averages were as follows,
would this information support or conflict with your evaluation in part b?
Why?


Inventory turnover 2000 2001 2002 2003

Bauman Company 6.3 6.8 7.0 6.4
Industry average 10.6 11.2 10.8 11.0



2–10 Inventory management Wilkins Manufacturing has sales of $4 million and a
LG3
gross profit margin of 40%. Its end-of-quarter inventories are


Quarter Inventory

1 $ 400,000
2 800,000
3 1,200,000
4 200,000



a. Find the average quarterly inventory and use it to calculate the firm’s inven-
tory turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory
turnover of 2.0, how would you evaluate the activity of Wilkins’
inventory?

2–11 Accounts receivable management An evaluation of the books of Blair Supply,
LG3
which follows, gives the end-of-year accounts receivable balance, which is
76 PART 1 Introduction to Managerial Finance


believed to consist of amounts originating in the months indicated. The
company had annual sales of $2.4 million. The firm extends 30-day credit
terms.


Month of origin Amounts receivable

July $ 3,875
August 2,000
September 34,025
October 15,100
November 52,000
December 193,000
Year-end accounts receivable $300,000



a. Use the year-end total to evaluate the firm’s collection system.
b. If 70% of the firm’s sales occur between July and December, would this
affect the validity of your conclusion in part a? Explain.


2–12 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has
LG4
requested a $4,000,000 loan, to assess the firm’s financial leverage and financial
risk. On the basis of the debt ratios for Creek, along with the industry averages
and Creek’s recent financial statements (which follow), evaluate and recommend
appropriate action on the loan request.



Creek Enterprises
Balance Sheet
December 31, 2003

Assets Liabilities and Stockholders’ Equity

Current assets Current liabilities
Cash $ 1,000,000 Accounts payable $ 8,000,000
Marketable securities 3,000,000 Notes payable 8,000,000
Accounts receivable 12,000,000 Accruals 500,000
Inventories 7,500,000 Total current liabilities $16,500,000
Long-term debt (includes financial leases)b
Total current assets $23,500,000 $20,000,000
cost)a
Gross fixed assets (at Stockholders’ equity
Land and buildings $11,000,000 Preferred stock (25,000 shares,
Machinery and equipment 20,500,000 $4 dividend) $ 2,500,000
Furniture and fixtures 8,000,000 Common stock (1 million shares at $5 par) 5,000,000
Gross fixed assets $39,500,000 Paid-in capital in excess of par value 4,000,000
Less: Accumulated depreciation 13,000,000 Retained earnings 2,000,000
Net fixed assets $26,500,000 Total stockholders’ equity $13,500,000
Total assets $50,000,000 Total liabilities and stockholders’ equity $50,000,000
aThe firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of the lease have yet to run.
bRequired annual principal payments are $800,000.
77
CHAPTER 2 Financial Statements and Analysis


Creek Enterprises Industry averages
Income Statement
for the Year Ended December 31, 2003 Debt ratio 0.51
Times interest earned ratio 7.30
Sales revenue $30,000,000
Fixed-payment coverage ratio 1.85
Less: Cost of goods sold 21,000,000
Gross profits $ 9,000,000
Less: Operating expenses
Selling expense $3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expense 6,000,000
Operating profits $ 3,000,000
Less: Interest expense 1,000,000
Net profits before taxes $ 2,000,000
Less: Taxes (rate = 40%) 800,000
Net profits after taxes $ 1,200,000
Less: Preferred stock dividends 100,000
Earnings available for common stockholders $ 1,100,000




2–13 Common-size statement analysis A common-size income statement for Creek
LG5
Enterprises’ 2002 operations follows. Using the firm’s 2003 income statement
presented in problem 2–12, develop the 2003 common-size income statement
and compare it to the 2002 statement. Which areas require further analysis and
investigation?


Creek Enterprises
Common-size Income Statement
for the Year Ended December 31, 2002

Sales revenue ($35,000,000) 100.0%
Less: Cost of goods sold 65.9
Gross profits 34.1%
Less: Operating expenses
Selling expense 12.7%
General and administrative expenses 6.3
Lease expense 0.6
Depreciation expense 3.6
Total operating expense 23.2
Operating profits 10.9%
Less: Interest expense 1.5
Net profits before taxes 9.4%
Less: Taxes (rate 40%) 3.8
Net profits after taxes 5.6%
Less: Preferred stock dividends 0.1
Earnings available for common stockholders 5.5%
78 PART 1 Introduction to Managerial Finance


2–14 Dupont system of analysis Use the following ratio information for Johnson
LG6
International and the industry averages for Johnson’s line of business to:
a. Construct the DuPont system of analysis for both Johnson and the
industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?


2001 2002 2003

Johnson

Financial leverage multiplier 1.75 1.75 1.85
Net profit margin 0.059 0.058 0.049
Total asset turnover 2.11 2.18 2.34

Industry Averages

Financial leverage multiplier 1.67 1.69 1.64
Net profit margin 0.054 0.047 0.041
Total asset turnover 2.05 2.13 2.15




2–15 Cross-sectional ratio analysis Use the following financial statements for Fox
LG6
Manufacturing Company for the year ended December 31, 2003, along with the
industry average ratios also given in what follows, to:
a. Prepare and interpret a complete ratio analysis of the firm’s 2003 operations.
b. Summarize your findings and make recommendations.


Fox Manufacturing Company
Income Statement
for the Year Ended December 31, 2003

Sales revenue $600,000
Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Net profits after taxes (earnings available
for common stockholders) $ 42,900

Earnings per share (EPS) $2.15
79
CHAPTER 2 Financial Statements and Analysis


Fox Manufacturing Company
Balance Sheet
December 31, 2003

Assets

Cash $ 15,000
Marketable securities 7,200
Accounts receivable 34,100
Inventories 82,000
Total current assets $138,300
Net fixed assets $270,000
Total assets $408,300

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000
Notes payable 13,000
Accruals 5,000
Total current liabilities $ 75,000
Long-term debt $150,000
Stockholders’ equity
Common stock equity (20,000 shares outstanding) $110,200
Retained earnings 73,100
Total stockholders’ equity $183,300
Total liabilities and stockholders’ equity $408,300




Ratio Industry average, 2003

Current ratio 2.35
Quick ratio 0.87
Inventory turnover a 4.55
Average collection perioda 35.3 days
Total asset turnover 1.09
Debt ratio 0.300
Times interest earned ratio 12.3
Gross profit margin 0.202
Operating profit margin 0.135
Net profit margin 0.091
Return on total assets (ROA) 0.099
Return on common equity (ROE) 0.167
Earnings per share (EPS) $3.10
aBased on a 360-day year and on end-of-year figures.
80 PART 1 Introduction to Managerial Finance


2–16 Financial statement analysis The financial statements of Zach Industries for the
LG6
year ended December 31, 2003, follow.



Zach Industries
Income Statement
for the Year Ended December 31, 2003

Sales revenue $160,000
Less: Cost of goods sold 106,000
Gross profits $ 54,000
Less: Operating expenses
Selling expense $ 16,000
General and administrative expenses 10,000
Lease expense 1,000
Depreciation expense 10,000
Total operating expense $ 37,000
Operating profits $ 17,000
Less: Interest expense 6,100
Net profits before taxes $ 10,900
Less: Taxes 4,360
Net profits after taxes $ 6,540




Zach Industries
Balance Sheet
December 31, 2003

Assets

Cash $ 500
Marketable securities 1,000
Accounts receivable 25,000
Inventories 45,500
Total current assets $ 72,000
Land $ 26,000
Buildings and equipment 90,000
Less: Accumulated depreciation 38,000
Net fixed assets $ 78,000
Total assets $150,000

Liabilities and Stockholders’ Equity

Accounts payable $ 22,000
Notes payable 47,000
Total current liabilities $ 69,000
Long-term debt $ 22,950
Common stocka $ 31,500
Retained earnings $ 26,550
Total liabilities and stockholders’ equity $150,000
aThefirm’s 3,000 outstanding shares of common stock closed
2003 at a price of $25 per share.
81
CHAPTER 2 Financial Statements and Analysis


a. Use the preceding financial statements to complete the following table.
Assume that the industry averages given in the table are applicable for both
2002 and 2003.

Industry
Ratio average Actual 2002 Actual 2003

Current ratio 1.80 1.84
Quick ratio 0.70 0.78
Inventory turnovera 2.50 2.59
Average collection perioda 37 days 36 days
Debt ratio 65% 67%
Times interest earned ratio 3.8 4.0
Gross profit margin 38% 40%
Net profit margin 3.5% 3.6%
Return on total assets 4.0% 4.0%
Return on common equity 9.5% 8.0%
Market/book ratio 1.1 1.2
aBased on 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 com-
pany’s overall financial condition.

2–17 Integrative—Complete ratio analysis Given the following financial statements,
LG6
historical ratios, and industry averages, calculate Sterling Company’s financial
ratios for the most recent year. Analyze its overall financial situation from both
a cross-sectional and a time-series viewpoint. Break your analysis into evalua-
tions of the firm’s liquidity, activity, debt, profitability, and market.

Sterling Company
Income Statement
for the Year Ended December 31, 2003

Sales revenue $10,000,000
Less: Cost of goods sold 7,500,000
Gross profits $ 2,500,000
Less: Operating expenses
Selling expense $300,000
General and administrative expenses 650,000
Lease expense 50,000

<<

ńňđ. 2
(âńĺăî 3)

ŃÎÄĹĐĆŔÍČĹ

>>