Вы находитесь на странице: 1из 54

Part2

FinancialTools
ChaptersinthisPart
Chapter3

FinancialStatementsandRatioAnalysis

Chapter4

CashFlowandFinancialPlanning

Chapter5

TimeValueofMoney

Integrative Case 2: Track Software, Inc.

Chapter3
FinancialStatementsandRatioAnalysis
Instructors Resources

Overview

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis25

Thischapterexaminesfourkeycomponentsofthestockholdersreport:theincomestatement,balance
sheet,statementofretainedearnings,andthestatementofcashflows.Ontheincomestatementandbalance
sheet,themajoraccounts/balancesarereviewedforthestudent.Therulesforconsolidatingacompanys
foreignanddomesticfinancialstatements(FASBNo.52)aredescribed.Followingthefinancialstatement
coveragethechaptercoverstheevaluationoffinancialstatementsusingthetechniqueofratioanalysis.
Ratioanalysisisusedbyprospectiveshareholders,creditors,andthefirmsownmanagementtomeasure
thefirmsoperatingandfinancialhealth.Threetypesofcomparativeanalysisaredefined:crosssectional
analysis,timeseriesanalysis,andcombinedanalysis.Theratiosaredividedintofivebasiccategories:
liquidity,activity,debt,profitability,andmarket.Eachratioisdefinedandcalculatedusingthefinancial
statementsoftheBartlettCompany.Abriefexplanationoftheimplicationsofdeviationfromindustry
standardratiosisoffered,withacomplete(crosssectionalandtimeseries)ratioanalysisofBartlettCompany
endingthechapter.TheDuPontsystemofanalysisisalsointegratedintotheexample.Theimportanceof
understandingfinancialstatementsishighlightedthroughdiscussionsofhowsuchknowledgewillhelpthe
studentbeamoreefficientbusinessmanagerandmoreeffectivelymakepersonalfinancialdecisions.

Suggested Answer to Opener in Review Question


InthechapteropeneryoureadabouthowfinancialanalystsgaveAbercrombiesstockarelatively
positiveoutlookbasedonacurrentratioof2.79,aquickratioof1.79,andareceivablescollection
periodof43days.Basedonwhatyoulearnedinthischapter,doyouagreewiththeanalysts
assessment?Explainwhyorwhynot.
Analystsattempttosimplifythejobofcompanyvaluationusingratiosdrawnfromfinancialreports.
Unfortunately,financialreportscoverpastperiodsandcannotpredictthefuturewith20/20vision.
Nonetheless,theanalystsmayhaveoversimplifiedtheanalysisiftheybasedtheiranalysisprimarilyon
Abercrombiesliquidityratios.Otherratiosshouldhaveplayedagreaterrole.Also,theanalystsshould
havebeenstudyingdomesticandforeigneconomicconditions,includingforecaststhereoftogaininsight
toAbercrombiesfuture.

Answers to Review Questions


1. TheroleoftheFinancialAccountingStandardsBoard(FASB)andPublicCompanyAccounting
OversightBoard(PCAOB)regulatoryagenciesinthefinancialreportingofbusinessesishighly
significant.Thegeneralacceptedaccountingstandardsthatfirmsmustcomplywithandtheprocedures
inmonitoringthosestandardsarereferredtoasgenerallyacceptedaccountingprocedures(GAAP)
andareestablishedprimarilybytheFASB.ThePCAOBhasasoneofitsprimarydutiesservingas
thewatchdogoverthepublicaccountingprofession.Publicaccountingfirmshavereportsthatmust
besubmittedtothePCAOBdocumentingcompliancewithauditingstandardsestablishedbythe
PCAOB.BoththeprocessofmonitoringtheaccountantsandtheuseofGAAPinfinancialreporting
arenecessarytorestoreandmaintainpublicconfidenceinthefinancialinformationdistributedto
thepublic.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis27

2. Thepurposeofeachofthefourmajorfinancialstatementsare:
IncomeStatementThepurposeoftheincomestatementistoprovideafinancialsummaryofthe
firmsoperatingresultsduringaspecifiedtimeperiod.Itincludesboththesalesforthefirmand
thecostsincurredingeneratingthosesales.Otherexpenses,suchastaxes,arealsoincludedon
thisstatement.

BalanceSheetThepurposeofthebalancesheetistopresentasummaryoftheassetsownedbythe
firm,theliabilitiesowedbythefirm,andthenetfinancialpositionoftheownersasofagivenpoint
intime.Theassetsareoftenreferredtoasinvestmentsandtheliabilitiesandownersequityas
financing.

StatementofRetainedEarningsThisstatementreconcilesthenetincomeearnedduringtheyear,
andanycashdividendspaid,withthechangeinretainedearningsduringtheyear.

StatementofCashFlowsThisstatementprovidesasummaryofthecashinflowsandthecash
outflowsexperiencedbythefirmduringtheperiodofconcern.Theinflowsandoutflowsaregrouped
intothecashflowareasofoperations,investment,andfinancing.

3. Thenotestothefinancialstatementsareimportantbecausetheyprovidedetailedinformationnot
directlyavailableinthefinancialstatements.Thefootnotesprovideinformationonaccounting
policies,procedures,calculation,andtransactionsunderlyingentriesinthefinancialstatements.
4. FinancialAccountingStandardsBoardStatementNo.52describestherulesforconsolidatinga
companysforeignanddomesticfinancialstatements.ItrequiresU.S.basedcompaniestotranslate
foreigncurrencydenominatedassetsandliabilitiesintoU.S.dollarsusingthecurrentrate(translation)
method.Thismethodusestheexchangerateprevailingonthedatethefiscalyearends(thecurrent
rate).Incomestatementitemscanbetranslatedusingeitherthecurrentrateoranaverageexchange
ratefortheperiodcoveredbythestatement.Equityaccountsareconvertedattheexchangerateon
thedateoftheinvestment.Intheretainedearningsaccountanygainsandlossesfromcurrencyfluctuations
arestatedseparatelyinanequityreserveaccount thecumulativetranslationadjustmentaccount and
notrealizeduntiltheparentcompanysellsorclosestheforeignoperations.
5. Currentandprospectiveshareholdersplaceprimaryemphasisonthefirmscurrentandfuturelevel
ofriskandreturnasmeasuresofprofitability,whilecreditorsaremoreconcernedwithshortterm
liquiditymeasuresofdebt.Stockholdersarethereforemostinterestedinincomestatementmeasures,
andcreditorsaremostconcernedwithbalancesheetmeasures.Managementisconcernedwithall
ratiomeasures,sincetheyrecognizethatstockholdersandcreditorsmustseegoodratiosinorderto
keepthestockpriceupandraisenewfunds.
2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis29

6. Crosssectionalcomparisonsaremadebycomparingsimilarratiosforfirmswithinthesameindustry,
ortoanindustryaverage,asofsomepointintime.Timeseriescomparisonsaremadebycomparing
similarratiosforafirmmeasuredatvariouspointsintime.Benchmarkingisthetermusedto
describethiscrosssectionalcomparisonwithcompetitorfirms.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis31

7. Theanalystshoulddevoteprimaryattentiontoanysignificantdeviationsfromthenorm,whether
aboveorbelow.Positivedeviationsfromthenormarenotnecessarilyfavorable.Anabovenormal
inventoryturnoverratiomayindicatehighlyefficientinventorymanagementbutmayalsoreveal
excessivelylowinventorylevelsresultinginstockouts.Furtherexaminationintothedeviationwould
berequired.

8. Comparingfinancialstatementsfromdifferentpointsintheyearcanresultininaccurateandmisleading
analysisduetotheeffectsofseasonality.Levelsofcurrentassetscanfluctuatesignificantly,depending
onacompanysbusiness,sostatementsfromthesamemonthoryearendshouldbeusedintheanalysis
toensurevalidcomparisonsofperformance.
9. Thecurrentratioprovestobethebetterliquiditymeasurewhenallofthefirmscurrentassetsare
reasonablyliquid.Thequickratiowouldprovetobethesuperiormeasureiftheinventoryofthe
firmisconsideredtolacktheabilitytobeeasilyconvertedintocash.
10. Largebusinessestypicallyhaveestablishedrelationshipswithbanksthatcanprovideaccesstoshort
termfundsintheeventthatthefirmhasaneedforliquidity.WholeFoods,thenaturalandorganic
grocerystore,needstohavemorerapidturnoverthaneventhetypicalgrocerystoreinordertokeep
freshproduceontheshelves.Itoffersamorefocusedfoodselection,reducingitsinventoryand
increasingitsinventoryturnoverratio.
11. Additionalinformationisnecessarytoassesshowwellafirmcollectsreceivablesandmeets
payables.Theaveragecollectionperiodofreceivablesshouldbecomparedtoafirmsowncredit
terms.Theaveragepaymentperiodshouldbecomparedtothecreditorscreditterms.
12. Financialleverageisthetermusedtodescribethemagnificationofriskandreturnintroduced
throughtheuseoffixedcostfinancing,suchasdebtandpreferredstock.
13. Thedebtratioandthedebtequityratiomaybeusedtomeasurethefirmsdegreeofindebtedness.
Thetimesinterestearnedandthefixedpaymentcoverageratioscanbeusedtoassessthefirms
abilitytomeetfixedpaymentsassociatedwithdebt.
14. Threeratiosofprofitabilityfoundonacommonsizeincomestatementare:(1)thegrossprofit
margin,(2)theoperatingprofitmargin,and(3)thenetprofitmargin.
15. Firmsthathavehighgrossprofitmarginsandlownetprofitmarginshavehighlevelsofexpenses
otherthancostofgoodssold.Inthiscase,thehighexpensesmorethancompensateforthelow
costofgoodssold(i.e.,highgrossprofitmargin),therebyresultinginalownetprofitmargin.
16. Theownersareprobablymostinterestedinthereturnonequity(ROE)sinceitindicatestherateof
returntheyearnontheirinvestmentinthefirm.ROEiscalculatedbytakingearningsavailableto
commonshareholderanddividingbystockholdersequity.
17. Thepriceearningsratio(P/E)isthemarketpricepershareofcommonstockdividedbytheearnings
pershare.Itindicatestheamounttheinvestoriswillingtopayforeachdollarofearnings.Itisused
2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis33

toassesstheownersappraisalofthevalueofthefirmsearnings.TheleveloftheP/Eratioindicates
thedegreeofconfidencethatinvestorshaveinthefirmsfuture.Themarket/book(M/B)ratioisthe
marketpriceperofcommonstockdividedbythefirmsbookvaluepershare.FirmswithhighM/B
ratiosareexpectedtoperformbetterthanfirmswithlowerrelativeM/Bvalues.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis35

18. Liquidityratiosmeasurehowwellthefirmcanmeetitscurrent(shortterm)obligationswhenthey
comedue.

Activityratiosareusedtomeasurethespeedwithwhichvariousaccountsareconverted(orcouldbe
converted)intocashorsales.

Debtratiosmeasurehowmuchofthefirmisfinancedwithotherpeoplesmoneyandthefirms
abilitytomeetfixedcharges.

Profitabilityratiosmeasureafirmsreturnwithrespecttosales,assets,orequity.

Marketratiosgiveinsightintohowwellinvestorsinthemarketplacefeelthefirmisdoinginterms
ofreturnandrisk.

Theliquidityanddebtratiosaremostimportanttopresentanyprospectivecreditors.

19. Theanalystmayapproachacompleteratioanalysisoneitheracrosssectionalortimeseriesbasis
bysummarizingtheratiosintotheirfivekeyareas:liquidity,activity,debt,profitability,andmarket.
Eachofthekeyareascouldthenbesummarized,highlightingspecificratiosthatshouldbeinvestigated.
20. TheDuPontsystemofanalysiscombinesprofitability(thenetprofitmargin),assetefficiency
(thetotalassetturnover)andleverage(thedebtratio).ThedivisionofROEamongthesethree
ratiosallowstheanalysttothesegregatethespecificfactorsthatarecontributingtotheROEinto
profitability,assetefficiency,ortheuseofdebt.

Suggested Answer to Global Focus Box: More Countries Adopt


International Financial Reporting Standards
WhatcostsandbenefitsmightbeassociatedwithaswitchtoIFRSintheUnitedStates?
ThetwokeycharacteristicsofthecurrentsystemoffinancialmarketsrelatedtocompaniesfollowingU.S.
GAAPpertaintothecorporatecostofcapitalandinvestorreturn.First,companiesseekingcapitalinthe
U.S.incurthelowestcostoffinancingintheworld.Second,asaconsequence,U.S.investorsreapthe
highestexpectedreturnsontheirinvestmentwhencomparedtoanyotherworldfinancialmarkets.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis37

Manybelievethathavinggoodaccountingrulesisafundamentalreasonforwhyitworkssowell.Thatwe
havegoodrules(betterthananyothersetevercreated)resultsfromaprocessthathasevolvedovertheyears.
Essentially,manyU.S.executiveswhoruncorporationswillbend/break/disregardanyrulethatgetsinthe
wayofreportingnumberstheexecutiveswantreported.U.S.auditorshavehadlittlesuccessovertheyears
ingettingcompaniestoreportgoodfaith,honestnumbers.Therehavebeencyclesofprosecutorstaking
companyexecstocourt,courtsrequiringmorespecificrulesforconvictions,andthenrulemakerstightening
therules.ItisfrequentlysaidthatAmericanaccountingrulesnowhavemanybrightlinesthatcompanies
mustabsolutelyfollowwhentheypreparefinancialstatements.Theentiresystemofcomplianceand
jurisprudencehasresultedintheU.S.makingveryexpensiveinvestmentsincreatingtheaccountingrules.
IFRSrules,whileastepupformany(orevenmost)ofthecountriesthathaveadoptedthem,actually
representastepbackwardsfortheU.S.,atleastinthebrightlinedepartment.SupportersofIFRSsaythe
brightlinesarenotneededbecausecompanyexecsaresupposedtodowhatisright.Thereareexceptions,
suchasthereportingforcontingencies,butforthemostpartitisU.S.GAAPthathasbrightlinesand
IFRSthatdoesnt.Consequently,companiesthatuseIFRSgettomassagetheirnumbers,andreported
earningsareatleast1015%higheronaverageunderIFRSthanGAAP.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis39

Suggested Answer to Focus on Ethics Box: Taking Earnings


Reports at Face Value

Whymightfinancialmanagersbetemptedtomanageearnings?
Financialmanagersincentivestructuresmighttemptthemtomanageearnings.Formanymanagers,
compensationistiedtotheirfirmsstockprice.Thisgivesmanagerstheincentivetotakeactionsthat
increasethestockprice.Ifearningsmanagementaccomplishesthis,managerscouldbetemptedtomanage
earnings.Additionally,financialmanagerscontinuedemploymentwiththefirmisgenerallycontingent
onfirmperformance.
Isitunethicalformanagerstomanageearningsiftheydisclosetheiractivitiestoinvestors?
Earningsmanagementisgenerallydesignedtomisleadinvestors.Actionstakenunderthispremiseare
generallyconsideredunethicalevenwhendisclosed.

Answers to Warm-Up Exercises


E31.

Prepareanincomestatement.

Answer:

a.
NameofCompany
IncomeStatement($000,000)
Salesrevenue
Less:Costofgoodssold
Grossprofits
Less:Operatingexpenses
Salesexpense
Generalandadministrativeexpenses
Leaseexpense
Depreciationexpense
Totaloperatingexpense
Operatingprofits(EBIT)
Less:Interestexpense

$345.0
255.0
$90.0
$18.0
22.0
4.0
25.0
$69.0
$21.0
3.0

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis41

Netprofitbeforetaxes
Less:Taxes(rate35%)
Netprofitsaftertaxes
Lessdividends($1.10x4.25millionshares)
Earningsavailableforcommonstockholders

$18.0
6.3
$11.7
4.675
$7.025

b. Seeincomestatement(thisamountstoabout$2.75pershare).

c. Additionstoretainedearningsistheportionleftafterpayingdividends,or$7,012,500.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis43

E32.

Incomestatementsandbalancestatements

Answer: Fromthetableina,thereadercanseethatthecalculationsbeginwithsalesrevenueandend
withnetprofitsaftertaxes.Hadtherebeenalossfortheyear,thefinalresultwouldhavebeen
anetlossaftertaxes.

Thebalancestatementbalancesthefirmsassetsagainstitsfinancing,whichcanbeeitherdebt
orequity.Thetotalvalueofallofthefirmsassetsshouldequalthesumofitsshortandlong
termdebtplusstockholdersequityincludingpreferredstock,commonstockatparvalue,paid
incapitalinexcessofparoncommonstockandretainedearningsfrompreviousprofitable
yearsinwhichsomeoftheearningswereheldbackandnotpaidoutasdividends.
E33.

Statementofretainedearnings

Answer:

CooperIndustries,Inc.
StatementofRetainedEarnings($000)
fortheYearEndedDecember31,2012
Retainedearningsbalance(January1,2011)
Plus:Netprofitsaftertaxes(for2012)
Less:Cashdividends(paidduring2012)
Preferredstock
Commonstock
Totaldividendspaid
Retainedearningsbalance(December31,2012)

$25,320
5,150
750
3,850

2012PearsonEducation,Inc.PublishingasPrenticeHall

4,600
$25,870

Chapter3FinancialStatementsandRatioAnalysis45

E34.

Currentratiosandquickratios

Answer: Thecurrentratioisincreasingbutthequickratioisdeclining.Sinceinventoryisincludedin
thecalculationofthecurrentratiobutnotinthequickratio,theratiosindicatethatinventory
isincreasingandBluestoneisnotoperatinginaleanmanufacturingmode.Aswithany
analysisusingratios,youshouldinvestigateotherfinancialratiosforBluestonetofurther
assessitsfinancialhealth.

E35.

TheDuPontmethodofcalculatingROE

Answer: ROE4.5%0.721.434.63%

TheadvantageofusingtheDuPontsystemtocalculateROEoverthedirectcalculationofearnings
availableforcommonstockholderscommonstockequityisthatROE,themostcommon
measureforstockholders,isbrokenintothreedistinctcomponents.Startingattherightwesee
howfinancialleveragehasincreasedassetsovertheownersoriginalequity.Next,movingto
theleft,weseehowefficientlythefirmuseditsassetstogeneratesales.Finally,thenetprofit
marginshowsthemeasureofprofitabilityonsales.Eachcomponentcanbecomparedwith
industrystandardstoseeifthefirmisunderperformingoroverperforminginanyoneofthe
threeareas.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis47

Solutions to Problems

P31.

Reviewingbasicfinancialstatements

LG1;Basic

Incomestatement:Inthisoneyearsummaryofthefirmsoperations,Technica,Inc.showeda
netprofitfor2012andtheabilitytopaycashdividendstoitsstockholders.

Balancesheet:ThefinancialconditionofTechnica,Inc.atDecember31,2011and2012isshown
asasummaryofassetsandliabilities.Technica,Inc.hasanexcessofcurrentassetsovercurrent
liabilities,demonstratingliquidity.Thefirmsfixedassetsrepresentoveronehalfoftotalassets
($270,000of$408,300).Thefirmisfinancedbyshorttermdebt,longtermdebt,commonstock,
andretainedearnings.Itappearsthatitrepurchased500sharesofcommonstockin2012.

Statementofretainedearnings:Technica,Inc.earnedanetprofitof$42,900in2012andpaid
out$20,000incashdividends.Thereconciliationoftheretainedearningsaccountfrom$50,200
to$73,100showsthenetamount($22,900)retainedbythefirm.

P32.

Financialstatementaccountidentification
LG1;Basic

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis49

(a)

(b)

Statement

TypeofAccount

Accountspayable

BS

CL

Accountsreceivable

BS

CA

Accruals

BS

CL

Accumulateddepreciation

BS

FA*

Administrativeexpense

IS

Buildings

BS

FA

Cash

BS

CA

AccountName

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis51

Commonstock(atpar)

BS

SE

Costofgoodssold

IS

Depreciation

IS

Equipment

BS

FA

Generalexpense

IS

Interestexpense

IS

Inventories

BS

CA

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis53

Land

BS

FA

Longtermdebt

BS

LTD

Machinery

BS

FA

Marketablesecurities

BS

CA

Notespayable

BS

CL

Operatingexpense

IS

Paidincapitalinexcessofpar

BS

SE

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis55

Preferredstock

BS

SE

Preferredstockdividends

IS

Retainedearnings

BS

SE

Salesrevenue

IS

Sellingexpense

IS

Taxes

IS

Vehicles

BS

FA

Thisisreallynotafixedasset,butachargeagainstafixedasset,betterknownasacontraasset.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis57

P33.

Incomestatementpreparation

LG1;Intermediate

a.
CathyChen,CPA
IncomeStatement
fortheYearEndedDecember31,2012
Salesrevenue
Less:Operatingexpenses
Salaries
Employmenttaxesandbenefits
Supplies
Travel&entertainment
Leasepayment
Depreciationexpense
Totaloperatingexpense
Operatingprofits
Less:Interestexpense
Netprofitsbeforetaxes
Less:Taxes(30%)
Netprofitsaftertaxes

$360,000
180,000
34,600
10,400
17,000
32,400
15,600

290,000
$70,000
15,000
$55,000
16,500
$38,500

b. Inherfirstyearofbusiness,CathyChencoveredallheroperatingexpensesandearnedanet
profitof$38,500onrevenuesof$360,000.

P34.

Personalfinance:Incomestatementpreparation

LG1;Intermediate

a.
Adamssalary

$45,000

Arinssalary

30,000

Interestreceived

500

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis59

Dividendsreceived

150

TotalIncome

$75,650

Expenses
Mortgagepayments

14,000

Utilityexpense

3,200

Groceries

2,200

Autoloanpayment

3,300

Homeinsurance

750

Autoinsurance

600

Medicalexpenses

1,500

Propertytaxes

1,659

Incometaxandsocialsecurity

13,000

Clothesandaccessories

2,000

Gasandautorepair

2,100

Entertainment

2,000

TotalExpenses

$46,309

CashSurplusor(Deficit)

$29,341

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis61

b. Sinceincomeexceedsexpenses,theAdamshaveacashsurplus.
c.

P35.

Thecashsurpluscanbeusedforavarietyofpurposes.Intheshortterm,theymayreplace
theircar,buybetterfurniture,ormorequicklypayofftheirhome.Alternatively,theymay
purchasestocksandbonds,orincreasetheirsavingsforfutureneeds.Investmentsinthestock
marketaregenerallydesignedtoincreaseanindividualsfuturewealth,thepurchaseofbonds
typicallyallowsonetoatleastretaintheirpurchasingpower,whileinvestmentinsavings
accountsprovidesliquidity.

CalculationofEPSandretainedearnings
LG1;Intermediate
a.

Earningspershare:
Netprofitbeforetaxes

$218,000

Less:Taxesat40%

87,200

Netprofitaftertax

$130,800

Less:Preferredstockdividends

Earningsavailabletocommonstockholders

32,000

$98,800

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis63

Earningspershare

Earningavailabletocommonstockholders $98,800

$1.162
Totalsharesoutstanding
85,000

b. Amounttoretainedearnings:
85,000shares$0.80$68,000commonstockdividends
Earningsavailabletocommonshareholders
Less:Commonstockdividends
Toretainedearnings
P36.

Incomestatementpreparation
LG1;Intermediate
OwenDavisCompany
BalanceSheet
December31,2012
Assets
Currentassets:
Cash
Marketablesecurities
Accountsreceivable
Inventories
Totalcurrentassets
Grossfixedassets
Landandbuildings
Machineryandequipment
Furnitureandfixtures
Vehicles
Totalgrossfixedassets
Less:Accumulateddepreciation
Netfixedassets
Totalassets

$215,000
75,000
450,000
375,000
$1,115,000
$325,000
560,000
170,000
25,000
$1,080,000
265,000
$815,000
$1,930,000

2012PearsonEducation,Inc.PublishingasPrenticeHall

$98,800
68,000
$30,800

Chapter3FinancialStatementsandRatioAnalysis65

Liabilitiesandstockholdersequity
Currentliabilities:
Accountspayable
Notespayable
Accruals
Totalcurrentliabilities
Longtermdebt
Totalliabilities
Stockholdersequity
Preferredstock
Commonstock(atpar)
Paidincapitalinexcessofpar
Retainedearnings
Totalstockholdersequity
Totalliabilitiesandstockholdersequity
P37.

$220,000
475,000
55,000
$750,000
420,000
$1,170,000
$100,000
90,000
360,000
210,000
$760,000
$1,930,000

PersonalFinance:Balancesheetpreparation
LG1;Basic

a.
AdamandArinAdams

BalanceSheet

December31,2012
Assets

LiabilitiesandNetWorth

Cash

$300

Utilitybills

$150

Checking

3,000

Medicalbills

Savings

1,200

Creditcardbalance

2,000

TotalCurrentLiabilities

$2,400

Moneymarketfunds

1,200

2012PearsonEducation,Inc.PublishingasPrenticeHall

250

Chapter3FinancialStatementsandRatioAnalysis67

TotalLiquidAssets

IBMstock

$5,700

2,000

Mortgage

100,000

Autoloan

8,000

Retirementfunds,IRA

2,000

Personalloan

3,000

TotalInvestments

$4,000

TotalLongTermLiabilities

$111,000

TotalRealEstate

$150,000

TotalLiabilities

$113,400

TotalNetWorth

76,500

TotalLiabilitiesandNetWorth

$189,900

2011Sebring

15,000

2010Jeep

8,000

Householdfurnishings

4,200

Jewelryandartwork

3,000

TotalPersonalProperty

$30,200

TotalAssets

$189,900

b. TotalassetsoftheAdamsfamilymustequalitsdebtplustheextenttowhichithaseither
experiencedagaininvalueorpaidthecostofanasset(itsnetworth).

c.

WorkingCapitalTotalLiquidAssetsTotalCurrentLiabilities
WorkingCapital$5,700$2,400$3,300

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis69

P38.

Impactofnetincomeonafirmsbalancesheet

LG1;Basic
Beginning
Value

Account

Change

Ending
Value

a.

Marketablesecurities

$35,000

$1,365,000

$1,400,000

b.

Retainedearnings
Longtermdebt

$1,575,000
$2,700,000

$1,365,000
$865,000

$2,940,000
$1,835,000

c.

Retainedearnings
Buildings

$1,575,000
$1,600,000

$865,000
$865,000

$2,440,000
$2,465,000

Retainedearnings

$1,575,000

$865,000

$2,440,000

d.

Nonetchangeinanyaccounts

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis71

P39.

Initialsalepriceofcommonstock
LG1;Basic

(Parvalueofcommonstock
Paidincapitalinexcessofpar)
Initialsalesprice
Numberofcommonsharesoutstanding

Initialsalesprice

$225,000 $2,625,000
$9.50pershare
300,000

P310. Statementofretainedearnings
LG1;Intermediate
a.

CashdividendspaidoncommonstockNetprofitsaftertaxespreferred
dividendschangeinretainedearnings

$377,000$47,000(1,048,000$928,000)

$210,000
HayesEnterprises
StatementofRetainedEarnings
fortheYearEndedDecember31,2012
Retainedearningsbalance(January1,2011)
Plus:Netprofitsaftertaxes(for2012)
Less:Cashdividends(paidduring2012)
Preferredstock
Commonstock
Retainedearnings(December31,2012)

$928,000
377,000
(47,000)
(210,000)
$1,048,000

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis73

Earningspershare

Netprofitaftertax Preferreddividends(EACS* )
Numberofcommonsharesoutstanding

Earningspershare

$377,000 $47,000
$2.36
140,000

b.

Earningsavailabletocommonstockholders

Cashdividendpershare

Totalcashdividend
#shares

Cashdividendpershare

$210,000(fromParta)
$1.50
140,000

c.

P311. Changesinstockholdersequity
LG1;Intermediate
a.

Netincomefor2012changeinretainedearningsdividendspaid

Netincomefor2012($1,500,000$1,000,000)$200,000$700,000
b. Newsharesissuedoutstandingshares2012outstandingshares2011
Newsharesissued1,500,000500,0001,000,000
Averageissuanceprice
Averageissuanceprice

Paidincapital Commonstock
sharesoutstanding

$4,000,000 $1,000,000
$5.00
1,000,000

c.
Originalissuanceprice
Originalissuanceprice

Paidincapital Commonstock
Numberofsharesissued

$500,000 $500,000
$2.00
500,000

d.
2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis75

P312. Ratiocomparisons
LG2,3,4,5;Basic
a.

Thefourcompaniesareinverydifferentindustries.Theoperatingcharacteristicsoffirms
acrossdifferentindustriesvarysignificantly,resultinginverydifferentratiovalues.

b. Theexplanationforthelowercurrentandquickratiosmostlikelyrestsonthefactthatthese
twoindustriesoperateprimarilyonacashbasis.Theiraccountsreceivablebalancesaregoing
tobemuchlowerthanfortheothertwocompanies.
c.

Highlevelofdebtcanbemaintainedifthefirmhasalarge,predictable,andsteadycashflow.
Utilitiestendtomeetthesecashflowrequirements.Thesoftwarefirmwillhaveveryuncertain
andchangingcashflow.Thesoftwareindustryissubjecttogreatercompetitionresultingin
morevolatilecashflow.

d. Althoughthesoftwareindustryhaspotentiallyhighprofitsandinvestmentreturnperformance,
italsohasalargeamountofuncertaintyassociatedwiththeprofits.Also,byplacingallof
themoneyinonestock,thebenefitsofreducedriskassociatedwithdiversificationarelost.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis77

P313. Liquiditymanagement

LG3;Basic

a.
Currentratio
Quickratio
Networkingcapital

2009

2010

2011

2012

1.88
1.22
$7,950

1.74
1.19
$9,300

1.79
1.24
$9,900

1.55
1.14
$9,600

b. Thepatternindicatesadeterioratingliquidityposition.Thedeclineismostpronouncedfor
thecurrentratiowhichincludesinventory.
c.

Thelowinventoryturnoversuggeststhatliquidityisevenworsethanthedecliningliquidity
measuresindicate.Slowinventoryturnovermayindicateobsoleteinventory.

P314. Personalfinance:Liquidityratio

LG3;Basic

Liquityratio

Totalliquidassets $3,200+$1,000+$800 $5,000

=
=2.38
Totalcurrentdebts
$1,200+$900
$2,100

a.
b. SinceJoshsliquidityratioexceeds1.8,Joshhasmoreliquiditythanhisbenchmarkfriends.
P315. Inventorymanagement
LG3;Basic
a.

Sales
Less:Grossprofit
Costofgoodssold

$4,000,000
$1,600,000
$2,400,000

100%
40%
60%

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis79

Averageinventory

$400,000 $800,000 $1,200,000 $200,000


$650,000
4

Inventoryturnover

Costofgoodssold $2,400,000

3.69times
Averageinventory
$650,000

Averageageofinventory

365
98.9days
3.69

b. TheWilkinsManufacturinginventoryturnoverratiosignificantlyexceedstheindustry.
Althoughthismayrepresentefficientinventorymanagement,itmayalsorepresentlow
inventorylevelsresultinginstockouts.
P316. Accountsreceivablemanagement
LG3;Basic
a.

Averagecollectionperiodaccountsreceivableaveragesalesperday
Averagecollectionperiod

$300,000
$300,000

45.62days
$2,400,000 6,575.34
365

Sincetheaverageageofreceivablesisover15daysbeyondthenetdate,attentionshouldbe
directedtoaccountsreceivablemanagement.
b. Thismayexplainthelowerturnoverandhigheraveragecollectionperiod.TheDecember
accountsreceivablebalanceof$300,000maynotbeagoodmeasureoftheaverageaccounts
receivable,therebycausingthecalculatedaveragecollectionperiodtobeoverstated.Italso
suggeststheNovemberfigure(030daysoverdue)isnotacauseforgreatconcern.However,
13%ofallaccountsreceivable(thosearisinginJuly,August,andSeptember)are60daysor
moreoverdueandmaybeasignofpoorreceivablesmanagement.
P317. Interpretingliquidityandactivityratios
LG3;Intermediate
a.

Bluegrassappearstobeholdingexcessinventoryrelativetotheindustry.Thisfactissupported
bythelowinventoryturnoverandthelowquickratio,eventhoughthecurrentratioisabove
theindustryaverage.Thisexcessinventorycouldbeduetoslowsalesrelativetoproduction
orpossiblyfromcarryingobsoleteinventory.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis81

b. TheaccountsreceivableofBluegrassappearstobehighduetothelargenumberofdaysof
salesoutstanding(73vs.theindustryaverageof52days).Animportantquestionforinternal
managementiswhetherthecompanyscreditpolicyistoolenientorcustomersarejustpaying
slowlyorpotentiallynotpayingatall.

c.

Sincethefirmispayingitsaccountspayablein31daysvs.theindustrynormof40days,
Bluegrassmaynotbetakingfulladvantageofcredittermsextendedtothembytheir
suppliers.Byhavingthereceivablescollectionperiodovertwiceaslongasthepayables
paymentperiod,thefirmisfinancingasignificantamountofcurrentassets,possiblyfrom
longtermsources.

d. Thedesireisthatmanagementwillbeabletocurtailthelevelofinventoryeitherbyreducing
productionorencouragingadditionalsalesthroughastrongersalesprogramordiscounts.If
theinventoryisobsolete,thenitmustbewrittenofftogaintheincometaxbenefit.Thefirm
mustalsopushtotrytogettheircustomerstopayearlier.Paymenttimingcanbeincreased
byshorteningcredittermsorprovidingadiscountforearlierpayment.Slowingdownthe
paymentofaccountspayablewouldalsoreducefinancingcosts.

Carryingouttheserecommendationsmaybedifficultbecauseofthepotentiallossofcustomers
duetostrictercreditterms.Thefirmwouldalsonotwanttoincreasetheircostsofpurchases
bydelayingpaymentbeyondanydiscountperiodgivenbytheirsuppliers.

P318. Debtanalysis

LG4;Basic

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis83

Ratio

Definition

Calculation

Debt

Debt
Totalassets

$36,500,000
$50,000,000

EBIT
Interest

$3,000,000
$1,000,000

Times

Creek
0.73

Industry
0.51

3.00

7.30

1.19

1.85

Interestearned

Fixed
Payment
Coverage
EBIT Leasepayment
Interest Leasepayments

$3,000,000 $200,000
$1,000,000 $200,000

{[(principalpreferredstock
Dividends)][1(1t)]}

{[($800,000$100,000)]
[1(10.4)]}

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis85

BecauseCreekEnterpriseshasamuchhigherdegreeofindebtednessandmuchlowerabilityto
servicedebtthantheaveragefirmintheindustry,theloanshouldberejected.
P319. Commonsizestatementanalysis
LG5;Intermediate
CreekEnterprises
CommonSizeIncomeStatement
fortheYearsEndedDecember31,2011and2012
2012

2011

Salesrevenue

100.0%

100.0%

Less:Costofgoodssold
Grossprofits

70.0%
30.0%

65.9%
34.1%

Less:Operatingexpenses:

Selling

10.0%

12.7%

General

6.0%

6.3%

Leaseexpense

0.7%

0.6%

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis87

Depreciation

3.3%

20.0%

3.6%

23.2%

Operatingprofits

10.0%

10.9%

Less:Interestexpense

3.3%

1.5%

NetProfitsbeforetaxes

6.7%

9.4%

Less:Taxes
Netprofitsaftertaxes

2.7%
4.0%

3.8%
5.6%

Saleshavedeclinedandcostofgoodssoldhasincreasedasapercentageofsales,probablydueto
alossofproductiveefficiency.Operatingexpenseshavedecreasedasapercentofsales;this
appearsfavorableunlessthisdeclinehascontributedtowardthefallinsales.Thelevelofinterest
asapercentageofsaleshasincreasedsignificantly;thisisverifiedbythehighdebtmeasuresin
Problem15,andsuggeststhatthefirmhastoomuchdebt.
Furtheranalysisshouldbedirectedattheincreasedcostofgoodssoldandthehighdebtlevel.
P320. Therelationshipbetweenfinancialleverageandprofitability

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis89

LG4,5;Challenge
Debtratio

a.

(1)

totalliabilities
totalassets

$1,000,000
0.10 10%
$10,000,000
$5,000,000
Debtratio Timberland
0.50 50%
$10,000,000
Debtratio Pelican

Timesinterestearned

(2)

earningbeforeinterestandtaxes
interest

$6,250,000
62.5
$100,000
$6,250,000
Timesinterestearned Timberland
12.5
$500,000
Timesinterestearned Pelican

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis91

TimberlandhasamuchhigherdegreeoffinancialleveragethandoesPelican.Asaresult,
Timberlandsearningswillbemorevolatile,causingthecommonstockownerstofacegreater
risk.Thisadditionalriskissupportedbythesignificantlylowertimesinterestearnedratioof
Timberland.Pelicancanfaceaverylargereductioninnetincomeandstillbeabletocoverits
interestexpense.
Operatingprofitmargin

b. (1)

operatingprofit
sales

$6,250,000
0.25 25%
$25,000,000
$6,250,000
Operatingprofitmargin Timberland
0.25 25%
$25,000,000
Operatingprofitmargin Pelican

Netprofitmargin

(2)

Earningsavailableforcommonstockholders
sales

$3,690,000
0.1476 14.76%
$25,000,000
$3,450,000
Netprofitmargin Timberland
0.138 13.80%
$25,000,000
Netprofitmargin Pelican

Returnontotalassets

(3)

Earningsavailableforcommonstockholders
totalassets

$3,690,000
0.369 36.9%
$10,000,000
$3,450,000
Returnontotalassets Timberland
0.345 34.5%
$10,000,000
Returnontotalassets Pelican

Returnoncommonequity

Earningsavailableforcommonstockholders
Commonstockequity

(4)

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis93

$3,690,000
0.41 41.0%
$9,000,000
$3,450,000
Returnoncommonequity Timberland
0.69 69.0%
$5,000,000
Returnoncommonequity Pelican

PelicanismoreprofitablethanTimberland,asshownbythehigheroperatingprofitmargin,
netprofitmargin,andreturnonassets.However,thereturnonequityforTimberlandis
higherthanthatofPelican.
c.

EventhoughPelicanismoreprofitable,TimberlandhasahigherROEthanPelicandueto
theadditionalfinancialleveragerisk.ThelowerprofitsofTimberlandareduetothefactthat
interestexpenseisdeductedfromEBIT.Timberlandhas$500,000ofinterestexpenseto
Pelicans$100,000.Evenafterthetaxshieldfromtheinteresttaxdeduction($500,000
0.40$200,000),TimberlandsprofitsarelessthanPelicansby$240,000.SinceTimberland
hasahigherrelativeamountofdebt,thestockholdersequityisproportionallyreduced
resultinginthehigherreturntoequitythanthatobtainedbyPelican.ThehigherROEbrings
withithigherlevelsoffinancialriskforTimberlandequityholders.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis95

P321. Ratioproficiency

LG6;Basic

a.

Grossprofit sales grossprofitmargin


Grossprofit $40,000,000 0.8 $32,000,000

b.

Costofgoodssold sales grossprofit


Costofgoodssold $40,000,000 $32,000,000 $8,000,000

c.

Operatingprofit sales operatingprofitmargin


Operatingprofit $40,000,000 0.35 $14,000,000

d.

Operatingexpenses grossprofit operatingprofit


Operatingexpenses $32,000,000 $14,000,000 $18,000,000

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis97

e.

Earningsavailableforcommonshareholders
sales netprofitmargin $40,000,000 0.08 $3,200,000

Totalassets

f.

sales
$40,000,000

$20,000,000
totalassetturnover
2

earningsavailableforcommonshareholders

ROE
$3,200,000
Totalcommonequity
$16,000,000
0.20
Totalcommonequity

g.

Accountsreceivable averagecollectionperiod
Accountsreceivable 62.2days
h.

sales

365

$40,000,000
62.2 $109,589.041 $6,816,438.36
365

P322. Crosssectionalratioanalysis

LG6;Intermediate

a.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis99

FoxManufacturingCompany
RatioAnalysis
IndustryAverage
2012

Actual
2012

Currentratio

2.35

1.84

Quickratio

0.87

0.75

Inventoryturnover

4.55times

5.61times

Averagecollectionperiod

35.8days

20.5days

Totalassetturnover

1.09

1.47

Debtratio

0.30

0.55

Timesinterestearned

Grossprofitmargin

12.3

0.202

8.0

0.233

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis101

Operatingprofitmargin

0.135

0.133

Netprofitmargin

0.091

0.072

Returnontotalassets

0.099

0.105

0.167
$3.10

0.234
$2.15

Returnoncommonequity
Earningspershare

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis103

Liquidity:Thecurrentandquickratiosshowaweakerpositionrelativetotheindustryaverage.

Activity:Allactivityratiosindicateafasterturnoverofassetscomparedtotheindustry.Further
analysisisnecessarytodeterminewhetherthefirmisinaweakerorstrongerpositionthanthe
industry.Ahigherinventoryturnoverratiomayindicatelowinventory,resultinginstockouts
andlostsales.Ashorteraveragecollectionperiodmayindicateextremelyefficientreceivables
management,anoverlyzealouscreditdepartment,orcredittermsthatprohibitgrowthinsales.

Debt:Thefirmusesmoredebtthantheaveragefirm,resultinginhigherinterestobligations
thatcouldreduceitsabilitytomeetotherfinancialobligations.

Profitability:Thefirmhasahighergrossprofitmarginthantheindustry,indicatingeithera
highersalespriceoralowercostofgoodssold.Theoperatingprofitmarginisinlinewiththe
industry,butthenetprofitmarginislowerthanindustry,anindicationthatexpensesotherthan
costofgoodssoldarehigherthantheindustry.Mostlikely,thedamagingfactorishighinterest
expensesduetoagreaterthanaverageamountofdebt.Theincreasedleverage,however,magnifies
thereturntheownersreceive,asevidencedbythesuperiorROE.
b. FoxManufacturingCompanyneedsimprovementinitsliquidityratiosandpossiblyareduction
initstotalliabilities.Thefirmismorehighlyleveragedthantheaveragefirminitsindustry
andthereforehasmorefinancialrisk.Theprofitabilityofthefirmislowerthanaveragebut
isenhancedbytheuseofdebtinthecapitalstructure,resultinginasuperiorROE.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis105

P323. Financialstatementanalysis

LG6;Intermediate

a.
ZachIndustries
RatioAnalysis
Industry
Average
Currentratio
Quickratio
Inventoryturnover
Averagecollectionperiod
Debtratio
Timesinterestearned
Grossprofitmargin
Netprofitmargin
Returnontotalassets
Returnoncommonequity
Market/bookratio

1.80
0.70
2.50
37.5days
65%
3.8
38%
3.5%
4.0%
9.5%
1.1

Actual
2011
1.84
0.78
2.59
36.5days
67%
4.0
40%
3.6%
4.0%
8.0%
1.2

Actual
2012
1.04
0.38
2.33
57days
61.3%
2.8
34%
4.1%
4.4%
11.3%
1.3

b. Liquidity:ZachIndustriesliquiditypositionhasdeterioratedfrom2011to2012andisinferior
totheindustryaverage.Thefirmmaynotbeabletosatisfyshorttermobligationsasthey
comedue.

Activity:ZachIndustriesabilitytoconvertassetsintocashhasdeterioratedfrom2011to2012.
Examinationintothecauseofthe20.5dayincreaseintheaveragecollectionperiodiswarranted.
Inventoryturnoverhasalsodecreasedfortheperiodunderreviewandisfaircomparedto
industry.Thefirmmaybeholdingslightlyexcessiveinventory.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis107

Debt:ZachIndustriesdebtpositionhasimprovedsince2011andisbelowaverage.Zach
Industriesabilitytoserviceinterestpaymentshasdeterioratedandisbelowtheindustryaverage.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis109

Profitability:AlthoughZachIndustriesgrossprofitmarginisbelowitsindustryaverage,
indicatinghighcostofgoodssold,thefirmhasasuperiornetprofitmarginincomparisonto
average.Thefirmhaslowerthanaverageoperatingexpenses.Thefirmhasasuperiorreturn
oninvestmentandreturnonequityincomparisontotheindustryandshowsanupwardtrend.

Market:ZachIndustriesincreaseintheirmarketpricerelativetotheirbookvaluepershare
indicatesthatthefirmsperformancehasbeeninterpretedasmorepositivein2012thanin
2011anditisalittlehigherthantheindustry.

Overall,thefirmmaintainssuperiorprofitabilityattheriskofilliquidity.Investigationinto
themanagementofaccountsreceivableandinventoryiswarranted.
P324. Integrativecompleteratioanalysis
LG6;Challenge
SterlingCompany
RatioAnalysis
Ratio

Actual
2010

Actual
2011

Actual
2012

Industry
Average TS:TimeSeries
2012
CS:CrossSectional

Currentratio

TS:Improving
1.40

1.55

1.67

1.85
CS:Fair

Quickratio

1.00

0.92

0.88

1.05

TS:Deteriorating
CS:Poor

Inventoryturnover

9.52

9.21

7.89

8.60

TS:Deteriorating
CS:Fair

Averagecollection
period

TS:Improving
45.6days

36.9days

29.2days 35.5days CS:Good

Averagepayment

TS:Unstable

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis111

period
Totalassetturnover

59.3days
0.74

61.6days
0.80

53.0days 46.4days CS:Poor


0.83

0.74

TS:Improving
CS:Good

Debtratio

0.20

0.20

0.35

0.30

TS:Increasing
CS:Fair

Timesinterestearned

8.2

7.3

6.5

8.0

TS:Deteriorating
CS:Poor

Fixedpayment

TS:Deteriorating

coverageratio

4.5

4.2

2.3

4.2

CS:Poor

Grossprofitmargin

0.30

0.27

0.25

0.25

TS:Deteriorating
CS:Average

Operatingprofit

TS:Improving

margin

0.12

0.12

0.13

0.10

CS:Good

Netprofitmargin

0.062

0.062

0.066

0.053

TS:Stable
CS:Good

Returnontotal
assets

TS:Stable
0.045

0.050

0.0508

0.040

Returnoncommon
Equity

TS:Improving
0.061

0.067

0.0782

0.066

Earningspershare
(EPS)

$1.75

$2.20

$3.05

$1.50

CS:Good
TS:Unstable

12.0

10.5

13.0

11.2

Market/bookratio
(M/B)

CS:Good
TS:Improving

Price/earnings
(P/E)

CS:Good

CS:Good
TS:Deteriorating

1.20

1.05

1.16

1.10

CS:Fair

Liquidity:SterlingCompanysoverallliquidityasreflectedbythecurrentratioandquickratio
appearstobefollowingdifferenttrends,butisbelowtheindustryaverage.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis113

Activity:Theactivityofaccountsreceivablehasimproved,butinventoryturnoverhas
deterioratedandiscurrentlybelowtheindustryaverage.Thefirmsaveragepaymentperiod
appearstohavespeededupfrom2010,althoughthefirmisstillpayingmoreslowlythanthe
averagecompany.

Debt:Thefirmsdebtratioshaveincreasedfrom2010andareveryclosetotheindustryaverages,
indicatingcurrentlyacceptablevaluesbutanundesirabletrend.Thefirmsfixedpayment
coveragehasdeclinedandiswellbelowtheindustryaveragefigure,indicatingadeteriorationin
servicingability.

Profitability:Thefirmsgrossprofitmargin,whileinlinewiththeindustryaverage,has
declined,probablyduetohighercostofgoodssold.Theoperatingandnetprofitmarginshave
beenstableandarealsoaboveindustryaverages.BoththeROAandtheROEappeartohave
improvedslightlyandarebetterthantheindustryaverages.EPSmadeasignificantincreasein
2011and2012.TheP/Eratioindicatesanincreasingdegreeofinvestorconfidenceinthefirms
futureearningspotential.

Market:ThefirmsP/Eratiowasgoodin2010,fellsignificantlyin2011,butrecoveredin2012.
Theratioisnowabovetheindustryaverage.Themarkettobookratioinitiallyshowedsignsof
improvingin2011and2012.ThemarketsinterpretationofSterlingsearningabilityindicatesa
lotofuncertainty.ThefluctuationintheM/Bratioalsoshowssignsofuncertainty.

Insummary,thefirmneedstoattendtoinventoryandaccountspayableandshouldnotincur
addeddebtsuntilitsleverageandfixedchargecoverageratiosareimproved.Otherthanthese
indicators,thefirmappearstobedoingwell especiallyingeneratingreturnonsales.The
marketseemstohavesomelackofconfidenceinthestabilityofSterlingsfuture.
P325. DuPontsystemofanalysis

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis115

LG6;Intermediate

a.
Margin(%)
2012
Johnson
Industry
2011
Johnson
Industry
2010
Johnson
Industry

Turnove
r

ROA(%)

FLMultiple

ROE(%)

4.9
4.1

2.34
2.15

11.47
8.82

1.85
1.64

21.21
14.46

5.8
4.7

2.18
2.13

12.64
10.01

1.75
1.69

22.13
16.92

5.9
5.4

2.11
2.05

12.45
11.07

1.75
1.67

21.79
18.49

b. Profitability:Industrynetprofitmarginsaredecreasing;Johnsonsnetprofitmarginshave
fallenless.

Efficiency:BothindustrysandJohnsonsassetturnoverhaveincreased.
Leverage:OnlyJohnsonshowsanincreaseinleveragefrom2011to2012,whiletheindustry
hashadlessstability.Between2010and2011,leveragefortheindustryincreased,whileit
decreasedbetween2011and2012.
Asaresultofthesechanges,theROEhasfallenforbothJohnsonandtheindustry,but
JohnsonhasexperiencedamuchsmallerdeclineinitsROE.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis117

c.

Areasthatrequirefurtheranalysisareprofitabilityanddebt.Sincethetotalassetturnoveris
increasingandissuperiortothatoftheindustry,Johnsonisgeneratinganappropriatesales
levelforthegivenlevelofassets.Butwhyisthenetprofitmarginfallingforbothindustry
andJohnson?Hastherebeenincreasedcompetitioncausingdownwardpressureonprices?
Isthecostofrawmaterials,labor,orotherexpensesrising?Acommonsizeincomestatement
couldbeusefulindeterminingthecauseofthefallingnetprofitmargin.
Note:Somemanagementteamsattempttomagnifyreturnsthroughtheuseofleverageto
offsetdecliningmargins.Thisstrategyiseffectiveonlywithinanarrowrange.Ahigh
leveragestrategymayactuallyresultinadeclineinstockpriceduetotheincreasedrisk.

P326. Completeratioanalysis,recognizingsignificantdifferences
LG6;Intermediate

a.
HomeHealth,Inc.
Ratio
Currentratio
Quickratio
Inventoryturnover
Averagecollectionperiod
Totalassetturnover
Debtratio
Timesinterestearned
Grossprofitmargin
Operatingprofitmargin
Netprofitmargin
Returnontotalassets
Returnoncommonequity
Price/earningsratio
Market/bookratio

2011
3.25
2.50
12.80
42.6days
1.40
0.45
4.00
68%
14%
8.3%
11.6%
21.1%
10.7
1.40

2012
Difference
3.00
0.25
2.20
0.30
10.30
2.50
31.4days 11.2days
2.00
0.60
0.62
0.17
3.85
0.15
65%
3%
16%
+2%
8.1%
0.2%
16.2%
4.6%
42.6%
21.5%
9.8
0.9
1.25
0.15

b.
Ratio

Proportional
Difference

Quickratio

12.00%

CompanysFavor
No

2012PearsonEducation,Inc.PublishingasPrenticeHall

Proportional
Difference
7.69%
12.00%
19.53%
26.29%
42.86%
37.78%
3.75%
4.41%
14.29%
2.41%
39.65%
101.90%
8.41%
10.71%

Chapter3FinancialStatementsandRatioAnalysis119

Inventoryturnover

19.53%

No

Averagecollectionperiod

26.29%

Yes

Totalassetturnover

42.86%

Yes

Debtratio

37.78%

No

Operatingprofitmargin

14.29%

Yes

Returnontotalassets

39.65%

Yes

101.90%
10.71%

Yes
No

Returnonequity
Market/bookratio

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis121

c.

ThemostobviousrelationshipisassociatedwiththeincreaseintheROEvalue.Theincrease
inthisratioisconnectedwiththeincreaseintheROA.ThehigherROAispartiallyattributed
tothehighertotalassetturnover(asreflectedintheDuPontmodel).TheROEincreaseisalso
associatedwiththeslightlyhigherlevelofdebtascapturedbythehigherdebtratio.

P327. Ethicsproblem

LG1;Intermediate
Answerswillvarybyarticlechosen,butingeneralstudentswillreportthatfinancialstatements
aremoretrustworthyifcompanyfinancialexecutivesimplementtheprovisionsofSOX.

Case

Casestudiesareavailableonwww.myfinancelab.com.

Assessing Martin Manufacturings Current Financial Position

MartinManufacturingCompanyisanintegrativecasestudyaddressingfinancialanalysistechniques.
Thecompanyisacapitalintensivefirmthathaspoormanagementofaccountsreceivableandinventory.
Theindustryaverageinventoryturnovercanfluctuatefrom10to100dependingonthemarket.
a. Ratiocalculations
FinancialRatio

2012

Currentratio
Quickratio
Inventoryturnover(times)
Averagecollectionperiod(days)
Totalassetturnover(times)
Debtratio
Timesinterestearned
Grossprofitmargin
Netprofitmargin
Returnontotalassets
Returnonequity

$1,531,181$616,0002.5%
($1,531,181$700,625)$616,0001.3%
$3,704,000$700,6255.3%
$805,556($5,075,000365)58.0%
$5,075,000$3,125,0001.6%
$1,781,250$3,125,00057%
$153,000$93,0001.6%
$1,371,000$5,075,00027%
$36,000$5,075,0000.71%
$36,000$3,125,0001.2%
$36,000$1,343,7502.7%

HistoricalRatios
MartinManufacturingCompany

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis123

Actual
2010

Actual
2011

Actual
2012

Industry
Average

Currentratio

1.7

1.8

2.5

1.5

Quickratio

1.0

0.9

1.3

1.2

Inventoryturnover(times)

5.2

5.0

5.3

10.2

50.7

55.8

58.0

46.0

1.5

1.5

1.6

2.0

45.8%

54.3%

2.2

1.9

1.6

2.5

27.5%

28.0%

27.0%

26.0%

Ratio

Averagecollectionperiod(days)

Totalassetturnover(times)

Debtratio

Timesinterestearned

Grossprofitmargin

57%

2012PearsonEducation,Inc.PublishingasPrenticeHall

24.5%

Chapter3FinancialStatementsandRatioAnalysis125

Netprofitmargin

1.1%

1.0%

0.71%

1.2%

Returnontotalassets

1.7%

1.5%

1.2%

2.4%

Returnonequity

3.1%

3.3%

2.7%

3.2%

Price/earningsratio

Market/book

33.5

38.7

34.48

43.4

1.0

1.1

0.89

1.2

b. Liquidity:Thefirmhassufficientcurrentassetstocovercurrentliabilities.Thetrendisupwardand
ismuchhigherthantheindustryaverage.Thisisanunfavorableposition,sinceitindicatestoomuch
inventory.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis127

Activity:Theinventoryturnoverisstablebutmuchlowerthantheindustryaverage.Thisindicates
thefirmisholdingtoomuchinventory.Theaveragecollectionperiodisincreasingandmuchhigher
thantheindustryaverage.Thesearebothindicatorsofaproblemincollectingpayment.

Thetotalassetturnoverratioisstablebutsignificantlylowerthantheindustryaverage.Thisindicates
thatthesalesvolumeisnotsufficientfortheamountofcommittedassets.

Debt:Thedebtratiohasincreasedandissubstantiallyhigherthantheindustryaverage.Thisplaces
thecompanyathighrisk.Typicallyindustrieswithheavycapitalinvestmentandhigheroperating
risktrytominimizefinancialrisk.MartinManufacturinghaspositioneditselfwithbothheavy
operatingandfinancialrisk.Thetimesinterestearnedratioalsoindicatesapotentialdebtservice
problem.Theratioisdecreasingandisfarbelowtheindustryaverage.

Profitability:Thegrossprofitmarginisstableandquitefavorablewhencomparedtotheindustry
average.Thenetprofitmargin,however,isdeterioratingandfarbelowtheindustryaverage.When
thegrossprofitmarginiswithinexpectationsbutthenetprofitmarginistoolow,highinterest
paymentsmaybetoblame.Thehighfinancialleveragehascausedthelowprofitability.

Market:Themarketpriceofthefirmscommonstockshowsweaknessrelativetobothearningsand
bookvalue.ThisresultindicatesabeliefbythemarketthatMartinsabilitytoearnfutureprofitsfaces
increasinguncertaintyasperceivedbythemarket.
c. MartinManufacturingclearlyhasaproblemwithitsinventorylevel,andsalesarenotatanappropriate
levelforitscapitalinvestment.Asaconsequence,thefirmhasacquiredasubstantialamountofdebt
which,duetothehighinterestpaymentsassociatedwiththelargedebtburden,isdepressingprofitability.
Theseproblemsarebeingpickedupbyinvestorsasshownintheirweakmarketratios.

2012PearsonEducation,Inc.PublishingasPrenticeHall

Chapter3FinancialStatementsandRatioAnalysis129

Spreadsheet Exercise
TheanswertoChapter3sDayton,Inc.,financialstatementsspreadsheetproblemislocatedonthe
InstructorsResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.

Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thischaptersgroupfocusessolelyonthegroupsshadowfirm.Groupsareaskedtoinvestigateanddescribe
theirfirmslatest10KobtainedfromtheSecuritiesandExchangewebsite(www.sec.gov).Fromthefiling
thegroupsareaskedtocalculatethebasicratiosasdoneinthetext,anddiscusseachratiosimportance.
Thisleadstoacomparisonoftheseratiosoverthemostrecentyears.Thenumberofyearsisuptotheinstructors
discretion.Ashorternumberofyearsisprobablymostdesirablesincethisoftencanbeaccomplishedfrom
thesingle10Kfiling.TheconclusionofthisassignmentiscalculationoftheDuPontanalysisfortheir
shadowfirm.Thisexerciseshouldntrequiremuchassistance,particularlyifstudentshavemadeagood
choicefortheirfirminChapter1.
Modificationscouldincludedroppingtheintertemporalanalysisandfocusingsolelyonthemostrecent
year.Alternatively,groupscouldbeaskedtocomparetheratiosfromtheirshadowfirmwiththeratios
fromanotherfirmwithinthesameindustry.

2012PearsonEducation,Inc.PublishingasPrenticeHall