Chapter 4

Analysis of Financial Statements

Learning Objectives
After reading this chapter, students should be able to:
Explain why ratio analysis is usually the frst step in the analysis of a companys fnancial
statements.
List the fve groups of ratios, specify which ratios belong in each group, and explain what
information each group gives us about the frms fnancial position.
tate what trend analysis is, and why it is important.
!escribe how the basic !u "ont e#uation is used, and how it may be modifed to form the
extended !u "ont e#uation, which includes the e$ect of fnancial leverage.
Explain %benchmar&ing' and its purpose.
List several limitations of ratio analysis.
(dentify some of the problems with )*E that can arise when frms use it as a sole measure of
performance.
(dentify some of the #ualitative factors that must be considered when evaluating a
companys fnancial performance.
Chapter 4: Analysis of Financial Statements Learning Objectives 73
Lecture Suggestions
+hapter , shows how fnancial statements are analy-ed to determine frms strengths and
wea&nesses. *n the basis of this information, management can ta&e actions to exploit
strengths and correct wea&nesses.
At .lorida, we fnd a signifcant di$erence in preparation between our accounting and
non/accounting students. 0he accountants are relatively familiar with fnancial statements, and
they have covered in depth in their fnancial accounting course many of the ratios discussed in
+hapter ,. 1e pitch our lectures to the non/accountants, which means concentrating on the use
of statements and ratios, and the %big picture,' rather than on details such as seasonal
ad2ustments and the e$ects of di$erent accounting procedures. !etails are important, but so
are general principles, and there are courses other than the introductory fnance course where
details can be addressed.
1hat we cover, and the way we cover it, can be seen by scanning the slides and
(ntegrated +ase solution for +hapter ,, which appears at the end of this chapter solution. .or
other suggestions about the lecture, please see the %Lecture uggestions' in +hapter 3, where
we describe how we conduct our classes.
A!S O" C#A$%&': 3 OF () A!S *(+,minute perio-s.
74 Lecture Suggestions Chapter 4: Analysis of Financial Statements
Ans/ers to &n-,of,Chapter 0uestions
4,1 0he emphasis of the various types of analysts is by no means uniform nor should it be.
4anagement is interested in all types of ratios for two reasons. .irst, the ratios point out
wea&nesses that should be strengthened5 second, management recogni-es that the
other parties are interested in all the ratios and that fnancial appearances must be &ept
up if the frm is to be regarded highly by creditors and e#uity investors. E#uity investors
6stoc&holders7 are interested primarily in proftability, but they examine the other ratios
to get information on the ris&iness of e#uity commitments. Long/term creditors are more
interested in the debt, 0(E, and E8(0!A coverage ratios, as well as the proftability ratios.
hort/term creditors emphasi-e li#uidity and loo& most carefully at the current ratio.
4,2 0he inventory turnover ratio is important to a grocery store because of the much larger
inventory re#uired and because some of that inventory is perishable. An insurance
company would have no inventory to spea& of since its line of business is selling
insurance policies or other similar fnancial products9contracts written on paper and
entered into between the company and the insured. 0his #uestion demonstrates that
the student should not ta&e a routine approach to fnancial analysis but rather should
examine the business that he or she is analy-ing.
4,3 :iven that sales have not changed, a decrease in the total assets turnover means that
the companys assets have increased. Also, the fact that the fxed assets turnover ratio
remained constant implies that the company increased its current assets. ince the
companys current ratio increased, and yet, its cash and e#uivalents and !* are
unchanged means that the company has increased its inventories.
4,4 !i$erences in the amounts of assets necessary to generate a dollar of sales cause asset
turnover ratios to vary among industries. .or example, a steel company needs a greater
number of dollars in assets to produce a dollar in sales than does a grocery store chain.
Also, proft margins and turnover ratios may vary due to di$erences in the amount of
expenses incurred to produce sales. .or example, one would expect a grocery store
chain to spend more per dollar of sales than does a steel company. *ften, a large
turnover will be associated with a low proft margin, and vice versa.
4,( (n;ation will cause earnings to increase, even if there is no increase in sales volume. <et,
the boo& value of the assets that produced the sales and the annual depreciation
expense remain at historic values and do not re;ect the actual cost of replacing those
assets. 0hus, ratios that compare current ;ows with historic values become distorted
over time. .or example, )*A will increase even though those assets are generating the
same sales volume.
1hen comparing di$erent companies, the age of the assets will greatly a$ect the
ratios. +ompanies with assets that were purchased earlier will re;ect lower asset values
than those that purchased assets later at in;ated prices. 0wo frms with similar physical
assets and sales could have signifcantly di$erent )*As. =nder in;ation, ratios will also
re;ect di$erences in the way frms treat inventories. As can be seen, in;ation a$ects
both income statement and balance sheet items.
4,3 )*E, using the extended !u "ont e#uation, is the return on assets multiplied by the
e#uity multiplier. 0he e#uity multiplier, defned as total assets divided by common
e#uity, is a measure of debt utili-ation5 the more debt a frm uses, the lower its e#uity,
Chapter 4: Analysis of Financial Statements Answers and Solutions 7(
and the higher the e#uity multiplier. 0hus, using more debt will increase the e#uity
multiplier, resulting in a higher )*E.
4,7 a4 +ash, receivables, and inventories, as well as current liabilities, vary over the year for
frms with seasonal sales patterns. 0herefore, those ratios that examine balance
sheet fgures will vary unless averages 6monthly ones are best7 are used.
b4 +ommon e#uity is determined at a point in time, say !ecember >?, 3@@A. "rofts are
earned over time, say during 3@@A. (f a frm is growing rapidly, year/end e#uity will
be much larger than beginning/of/year e#uity, so the calculated rate of return on
e#uity will be di$erent depending on whether end/of/year, beginning/of/year, or
average common e#uity is used as the denominator. Average common e#uity is
conceptually the best fgure to use. (n public utility rate cases, people are reported
to have deliberately used end/of/year or beginning/of/year e#uity to ma&e returns on
e#uity appear excessive or inade#uate. imilar problems can arise when a frm is
being evaluated.
4,) .irms within the same industry may employ di$erent accounting techni#ues that ma&e it
diBcult to compare fnancial ratios. 4ore fundamentally, comparisons may be
misleading if frms in the same industry di$er in their other investments. .or example,
comparing "epsico and +oca/+ola may be misleading because apart from their soft drin&
business, "epsi also owns other businesses, such as .rito/Lay.
4,5 0he three components of the extended !u "ont e#uation are proft margin, assets
turnover, and the e#uity multiplier. *ne would not expect the three components of the
discount merchandiser and high/end merchandiser to be the same even though their
)*Es are identical. 0he discount merchandisers proft margin would be lower than the
high/end merchandiser, while the assets turnover would be higher for the discount
merchandiser than for the high/end merchandiser.
4,1+ 0otal +urrent E$ect on
+urrent Assets )atio Cet (ncome
a4 +ash is ac#uired through issuance of additional
common stoc&. D D @
b4 4erchandise is sold for cash. D D D
c4 .ederal income tax due for the previous year is paid. E D @
-4 A fxed asset is sold for less than boo& value. D D E
e4 A fxed asset is sold for more than boo& value. D D D
f4 4erchandise is sold on credit. D D D
g4 "ayment is made to trade creditors for previous purchases. E D
@
h4 A cash dividend is declared and paid. E E @
i4 +ash is obtained through short/term ban& loans. D E @
j4 hort/term notes receivable are sold at a discount. E E E
64 4ar&etable securities are sold below cost. E E E
l4 Advances are made to employees. @ @ @
73 Answers and Solutions Chapter 4: Analysis of Financial Statements
m4 +urrent operating expenses are paid. E E E
n4 hort/term promissory notes are issued to trade creditors
in exchange for past due accounts payable. @ @ @
o4 ?@/year notes are issued to pay o$ accounts payable.@ D @
0otal +urrent E$ect on
+urrent Assets )atio Cet (ncome
p4 A fully depreciated asset is retired. @ @ @
74 Accounts receivable are collected. @ @ @
r4 E#uipment is purchased with short/term notes. @ E @
s4 4erchandise is purchased on credit. D E @
t4 0he estimated taxes payable are increased. @ E E
Chapter 4: Analysis of Financial Statements Answers and Solutions 77
Solutions of &n-,of,Chapter $roblems
4,1 !* F ,@ days5 F GH,>@@,@@@5 A) F I
!*F
>JA

A)
,@ F
K>JA @@@ , >@@ , H G
A)
,@ F A)KG3@,@@@
A) F GL@@,@@@.
4,2 AKE F 3.,5 !KA F I
AL.>>M. F @.AL>> F
A
!
3.,
?
/ ? F
A
!
E
A
?
/ ? F
A
!

4,3 )*A F ?@M5 "4 F 3M5 )*E F ?AM5 K0A F I5 0AKE F I

)*A F C(KA5 "4 F C(K5 )*E F C(KE.
)*AF "4 K0A
C(KA F C(K K0A
?@MF 3M K0A
K0AF 0A0* F A.
)*EF "4 K0A 0AKE
C(KE F C(K K0A 0AKE
?AMF 3M A 0AKE
?AMF ?@M 0AKE
0AKEF E4 F ?.A.
4,4 0A F G?@,@@@,@@@,@@@5 +L F G?,@@@,@@@,@@@5 L0 debt F G>,@@@,@@@,@@@5 +E F
GJ,@@@,@@@,@@@5 hares outstanding F L@@,@@@,@@@5 "@ F G>35 4K8 F I
8oo& value F
@@@ , @@@ , L@@
@@@ , @@@ , @@@ , J G
F GH.A@.
4K8 F
A@ . H G
@@ . >3 G
F ,.3JJH.
7) Answers and Solutions Chapter 4: Analysis of Financial Statements
4,( E" F G3.@@5 +." F G>@@5 "K+. F L.@5 "KE F I
"K+. F L.@
"KG>.@@ F L.@
" F G3,.@@.
"KE F G3,.@@KG3.@@ F ?3.@.
4,3 "4 F 3M5 E4 F 3.@5 ales F G?@@,@@@,@@@5 Assets F GA@,@@@,@@@5 )*E F I
)*EF "4 0A0* E4
F C(K K0A AKE
F 3M G?@@,@@@,@@KGA@,@@@,@@@ 3
F LM.
4,7 tep ?: +alculate total assets from information given.
ales F GJ million.
>.3 F alesK0A
>.3 F
Assets
@@@ , @@@ , J G
Assets F G?,LHA,@@@.
tep 3: +alculate net income.
0here is A@M debt and A@M e#uity, so E#uity F G?,LHA,@@@ @.A F GN>H,A@@.
)*E F C(K K0A 0AKE
@.?3 F C(KGJ,@@@,@@@ >.3 G?,LHA,@@@KGN>H,A@@
@.?3 F
@@@ , @@@ , J G
C( , . J
GH3@,@@@ F J.,C(
G??3,A@@ F C(.
4,) )*A F LM5 net income F GJ@@,@@@5 0A F I
)*AF
0A
C(
LMF
0A
@@@ , J@@ G
0A F GH,A@@,@@@.
0o calculate 8E", we still need E8(0. 0o calculate E8(0 construct a partial income
statement:
E8(0 G?,?,L,@HH 6G33A,@@@ D GN3>,@HH7
(nterest 33A,@@@ 6:iven7
E80 G N3>,@HH GJ@@,@@@K@.JA
0axes 6>AM7 >3>,@HH
C( G J@@,@@@
Chapter 4: Analysis of Financial Statements Answers and Solutions 75
8E" F
0A
E8(0
F
@@@ , A@@ , H G
@HH , ?,L , ? G
F @.?A>? F ?A.>?M.
4,5 toc&holders e#uity F G>,HA@,@@@,@@@5 4K8 F ?.N5 " F I
0otal mar&et value F G>,HA@,@@@,@@@6?.N7 F GH,?3A,@@@,@@@.
4ar&et value per share F GH,?3A,@@@,@@@KA@,@@@,@@@ F G?,3.A@.
Alternative solution:
toc&holders e#uity F G>,HA@,@@@,@@@5 hares outstanding F A@,@@@,@@@5 " F I
8oo& value per share F G>,HA@,@@@,@@@KA@,@@@,@@@ F GHA.
4ar&et value per share F GHA6?.N7 F G?,3.A@.
4,1+ 1e are given )*A F >M and alesK0otal assets F ?.A.
.rom the basic !u "ont e#uation:)*A F "roft margin 0otal assets turnover
>M F "roft margin6?.A7
"roft margin F >MK?.A F 3M.
1e can also calculate the companys debt ratio in a similar manner, given the facts of
the problem. 1e are given )*A6C(KA7 and )*E6C(KE75 if we use the reciprocal of )*E we
have the following e#uation:
,@M. F @.,@ F @.J@ ? F
A
!
. J@M F
A
E
@.@A
?
>M F
A
E
so ,
A
E
? F
A
!
and
C(
E

A
C(
F
A
E

Alternatively, using the extended !u "ont e#uation:
)*EF )*A E4
AM F >M E4
E4 F AMK>M F AK> F 0AKE.
0a&e reciprocal: EK0A F >KA F J@M5 therefore, !KA F ? E @.J@ F @.,@ F ,@M.
0hus, the frms proft margin F 3M and its debt ratio F ,@M.
)+ Answers and Solutions Chapter 4: Analysis of Financial Statements
4,11 0A F G>@,@@@,@@@,@@@5 E8(0K0A F 3@M5 0(E F L5 !A F G>,3@@,@@@,@@@5 Lease payments
F G3,@@@,@@@,@@@5 "rincipal payments F G?,@@@,@@@,@@@5 E8(0!A coverage F I
E8(0KG>@,@@@,@@@,@@@F @.3
E8(0 F GJ,@@@,@@@,@@@.
L F E8(0K(C0
L F GJ,@@@,@@@,@@@K(C0
(C0F GHA@,@@@,@@@.
E8(0!AF E8(0 D !A
F GJ,@@@,@@@,@@@ D G>,3@@,@@@,@@@
F GN,3@@,@@@,@@@.
E8(0!A coverage ratio F
pmts Lease pmts "rinc. (C0
payments Lease E8(0!A
+ +
+
F
@@@ , @@@ , @@@ , 3 G @@@ , @@@ , @@@ , ? G @@@ , @@@ , HA@ G
@@@ , @@@ , @@@ , 3 G @@@ , @@@ , 3@@ , N G
+ +
+
F
@@@ , @@@ , HA@ , > G
@@@ , @@@ , 3@@ , ?? G
F [Link].
4,12 0A F G?3,@@@,@@@,@@@5 0 F ,@M5 E8(0K0A F ?AM5 )*A F AM5 0(E F I
@@@ , @@@ , @@@ , ?3 G
E8(0
F @.?A
E8(0 F G?,L@@,@@@,@@@.
@@@ , @@@ , @@@ , ?3 G
C(
F @.@A
C( F GJ@@,@@@,@@@.
Cow use the income statement format to determine interest so you can calculate the
frms 0(E ratio.
E8(0 G?,L@@,@@@,@@@ ee above.
(C0 L@@,@@@,@@@
E80 G?,@@@,@@@,@@@ E80 F GJ@@,@@@,@@@K@.J
0axes 6,@M7 ,@@,@@@,@@@
C( G J@@,@@@,@@@ ee above.
0(E F E8(0K(C0
F G?,L@@,@@@,@@@KGL@@,@@@,@@@
F 3.3A.
Chapter 4: Analysis of Financial Statements Answers and Solutions )1
(C0 F E8(0 E E80
F G?,L@@,@@@,@@@ E G?,@@@,@@@,@@@
4,13 0(E F E8(0K(C0, so fnd E8(0 and (C0.
(nterest F GA@@,@@@ @.? F GA@,@@@.
Cet income F G3,@@@,@@@ @.@A F G?@@,@@@.
"re/tax income 6E807 F G?@@,@@@K6? E 07 F G?@@,@@@K@.H F G?,3,LAH.
E8(0 F E80 D (nterest F G?,3,LAH D GA@,@@@ F G?N3,LAH.
0(E F G?N3,LAHKGA@,@@@ F >.LJ.
4,14 )*EF "roft margin 0A turnover E#uity multiplier
F C(Kales alesK0A 0AKE#uity.
Cow we need to determine the inputs for the extended !u "ont e#uation from the data
that were given. *n the left we set up an income statement, and we put numbers in it
on the right:
ales 6given7 G?@,@@@,@@@
E +ost na
E8(0 6given7 G ?,@@@,@@@
E (C0 6given7 >@@,@@@
E80 G H@@,@@@
E 0axes 6>,M7 3>L,@@@
C( G ,J3,@@@
Cow we can use some ratios to get some more data:
0otal assets turnover F 3 F K0A5 0A F K3 F G?@,@@@,@@@K3 F GA,@@@,@@@.
!KA F J@M5 so EKA F ,@M5 and, therefore,
E#uity multiplier F 0AKE F ?K6EKA7 F ?K@., F 3.A.
Cow we can complete the extended !u "ont e#uation to determine )*E:
)*E F G,J3,@@@KG?@,@@@,@@@ G?@,@@@,@@@KGA,@@@,@@@ 3.A F @.3>? F 3>.?M.
4,1( +urrently, )*E is )*E? F G?A,@@@KG3@@,@@@ F [Link].
0he current ratio will be set such that 3.A F +AK+L. +L is GA@,@@@, and it will not
change, so we can solve to fnd the new level of current assets: +A F 3.A6+L7 F
3.A6GA@,@@@7 F G?3A,@@@. 0his is the level of current assets that will produce a current
ratio of 3.A.
At present, current assets amount to G3?@,@@@, so they can be reduced by G3?@,@@@
E G?3A,@@@ F GLA,@@@. (f the GLA,@@@ generated is used to retire common e#uity, then
the new common e#uity balance will be G3@@,@@@ E GLA,@@@ F G??A,@@@.
Assuming that net income is unchanged, the new )*E will be )*E3 F
G?A,@@@KG??A,@@@ F ?>.@,M. 0herefore, )*E will increase by ?>.@,M E H.A@M F A.A,M.
0he new +A level is G?3A,@@@5 +L remain at GA@,@@@5 and the new (nventory level F
G?A@,@@@ E GLA,@@@ F GJA,@@@. 0hus, the new #uic& ratio is calculated as follows:
Cew #uic& ratio F
+L
(nv +A
F
@@@ , A@ G
@@@ , JA G @@@ , ?3A G
F ?.3.
)2 Answers and Solutions Chapter 4: Analysis of Financial Statements
4,13 Onown data:
0A F G?,@@@,@@@5 (nt. rate F LM5 0 F ,@M5 8E" F @.3 F E8(0K0otal assets, so E8(0 F
@.36G?,@@@,@@@7 F G3@@,@@@5 !KA F @.A F A@M, so E#uity F GA@@,@@@.
!KA F @M !KA F A@M
E8(0 G3@@,@@@ G3@@,@@@
(nterest @ ,@,@@@P
E80 G3@@,@@@ G?J@,@@@
0ax 6,@M7 L@,@@@ J,,@@@
C( G?3@,@@@ G NJ,@@@
)*E F
E#uity
C(
F
G?,@@@,@@@
G?3@,@@@
F ?3M
GA@@,@@@
GNJ,@@@
F ?N.3M
!i$erence in )*E F ?N.3M E ?3.@M F H.3M.
P(f !KA F A@M, then half of the assets are fnanced by debt, so !ebt F GA@@,@@@. At an
LM interest rate, (C0 F G,@,@@@.
4,17 tatement a is correct. )efer to the solution setup for "roblem ,/?J and thin& about it this
way: 6?7 Adding assets will not a$ect common e#uity if the assets are fnanced with debt.
637 Adding assets will cause expected E8(0 to increase by the amount E8(0 F 8E"6added
assets7. 6>7 (nterest expense will increase by the amount (nt. rate6added assets7. 6,7 "re/
tax income will rise by the amount 6added assets768E" E (nt. rate7. Assuming 8E" Q (nt.
rate, if pre/tax income increases so will net income. 6A7 (f expected net income increases
but common e#uity is held constant, then the expected )*E will also increase. Cote that
if (nt. rate Q 8E", then adding assets fnanced by debt would lower net income and thus
the )*E. 0herefore, tatement a is true9if assets fnanced by debt are added, and if the
expected 8E" on those assets exceeds the interest rate on debt, then the frms )*E will
increase.
tatements b, c, and d are false, because the 8E" ratio uses E8(0, which is calculated
before the e$ects of taxes or interest charges are felt. *f course, tatement e is also
false.
4,1) 0A F GA,@@@,@@@,@@@5 0 F ,@M5 E8(0K0A F ?@M5 )*A F AM5 0(E I
. @@@ , @@@ , A@@ G E8(0
?@ . @
,@@@ GA,@@@,@@@
E8(0
=
=
. @@@ , @@@ , 3A@ G C(
@A . @
,@@@ GA,@@@,@@@
C(
=
=
Cow use the income statement format to determine interest so you can calculate the
frms 0(E ratio.
E8(0 GA@@,@@@,@@@ ee above.
(C0 L>,>>>,>>>
E80 G,?J,JJJ,JJH E80 F G3A@,@@@,@@@K@.J
Chapter 4: Analysis of Financial Statements Answers and Solutions )3
(C0 F E8(0 E E80
F GA@@,@@@,@@@ / G,?J,JJJ,JJH
0axes 6,@M7 ?JJ,JJJ,JJH
C( G3A@,@@@,@@@ ee above.
0(E F E8(0K(C0
F GA@@,@@@,@@@KGL>,>>>,>>>
F J.@.
4,15 "resent current ratio F
GA3A,@@@
G?,>?3,A@@
F 3.A.
4inimum current ratio F
C" D GA3A,@@@
C" D G?,>?3,A@@

F 3.@.
G?,>?3,A@@ D C" F G?,@A@,@@@ D 3C"
C" F G3J3,A@@.
hort/term debt can increase by a maximum of G3J3,A@@ without violating a 3 to ? current
ratio, assuming that the entire increase in notes payable is used to increase current assets.
ince we assumed that the additional funds would be used to increase inventory, the
inventory account will increase to GJ>H,A@@ and current assets will total G?,AHA,@@@, and
current liabilities will total GHLH,A@@.
4,2+ tep ?: olve for current annual sales using the !* e#uation:
AAF GHA@,@@@K6alesK>JA7
AAales F G3H>,HA@,@@@
ales F G,,NHH,3H3.H>.
tep 3: (f sales fall by ?AM, the new sales level will be G,,NHH,3H3.H>6@.LA7 F
G,,3>@,JL?.L3. Again, using the !* e#uation, solve for the new accounts
receivable fgure as follows:
>AF A)K6G,,3>@,JL?.L3K>JA7
>AF A)KG??,AN@.N?
A) F G,@A,JL?.L3 G,@A,JL3.
4,21 0he current E" is G3,@@@,@@@KA@@,@@@ shares or G,.@@. 0he current "KE ratio is then
G,@KG, F ?@.@@. 0he new number of shares outstanding will be JA@,@@@. 0hus, the new
E" F G>,3A@,@@@KJA@,@@@ F GA.@@. (f the shares are selling for ?@ times E", then they
must be selling for GA.@@6?@7 F GA@.
4,22 ?. 0otal debt F 6@.A@760otal assets7 F 6@.A@76G>@@,@@@7 F G?A@,@@@.
3. Accounts payable F 0otal debt E Long/term debt F G?A@,@@@ E GJ@,@@@
F GN@,@@@.
>. +ommon stoc& F
e#uity and
s liabilitie 0otal
E !ebt E )etained earnings
F G>@@,@@@ E G?A@,@@@ E GNH,A@@ F GA3,A@@.
,. ales F 6?.A760otal assets7 F 6?.A76G>@@,@@@7 F G,A@,@@@.
)4 Answers and Solutions Chapter 4: Analysis of Financial Statements
A. (nventories F alesKA F G,A@,@@@KA F GN@,@@@.
J. Accounts receivable F 6alesK>JA76!*7 F 6G,A@,@@@K>JA76>J.A7 F G,A,@@@.
H. +ash D Accounts receivable D (nventories F 6?.L76Accounts payable7
+ash D G,A,@@@ D GN@,@@@ F 6?.L76GN@,@@@7
+ash D G?>A,@@@ F G?J3,@@@
+ash F G3H,@@@.
L. .ixed assets F 0otal assets E 6+ash D Accts rec. D (nventories7
F G>@@,@@@ E 6G3H,@@@ D G,A,@@@ D GN@,@@@7
F G?>L,@@@.
N. +ost of goods sold F 6ales76? E @.3A7 F 6G,A@,@@@76@.HA7 F G>>H,A@@.
4,23 a4 6!ollar amounts in thousands.7
(ndustry
.irm Average
s liabilitie +urrent
assets +urrent
F
G>>@,@@@
GJAA,@@@
F ?.NL 3.@
s liabilitie +urrent
s (nventorie assets +urrent
F
G>>@,@@@
A@@ , 3,? G GJAA,@@@
F ?.3A ?.>
!
*
F
>JA alesK
receivable Accounts
F
?? . @, G,,,
G>>J,@@@
F
HJ.>
days
>A
days
s (nventorie
ales
F
G3,?,A@@
G?,J@H,A@@
F [Link] J.H
assets 0otal
ales
F
GN,H,A@@
G?,J@H,A@@
F ?.H@ >.@
ales
income Cet
F
G?,J@H,A@@
G3H,>@@
F ?.HM ?.3M
assets 0otal
income Cet
F
GN,H,A@@
G3H,>@@
F [Link] >.JM
e#uity +ommon
income Cet
F
G>J?,@@@
G3H,>@@
F [Link] N.@M
assets 0otal
debt 0otal
F
GN,H,A@@
GALJ,A@@
F J?.NM J@.@M
b4 .or the frm,
)*E F "4 0.A. turnover E4 F ?.HM ?.H
G>J?,@@@
GN,H,A@@
F [Link].
.or the industry, )*E F ?.3M > 3.A F NM.
Chapter 4: Analysis of Financial Statements Answers and Solutions )(
Cote: 0o fnd the industry ratio of assets to common e#uity, recogni-e that ? E 60otal
debtK0otal assets7 F +ommon e#uityK0otal assets. o, +ommon e#uityK0otal assets F
,@M, and ?K@.,@ F 3.A F 0otal assetsK+ommon e#uity.
c4 0he frms days sales outstanding is more than twice as long as the industry average,
indicating that the frm should tighten credit or enforce a more stringent collection
policy. 0he total assets turnover ratio is well below the industry average so sales
should be increased, assets decreased, or both. 1hile the companys proft margin is
higher than the industry average, its other proftability ratios are low compared to
the industry9net income should be higher given the amount of e#uity and assets.
Rowever, the company seems to be in an average li#uidity position and fnancial
leverage is similar to others in the industry.
-4 (f 3@@A represents a period of supernormal growth for the frm, ratios based on this
year will be distorted and a comparison between them and industry averages will
have little meaning. "otential investors who loo& only at 3@@A ratios will be misled,
and a return to normal conditions in 3@@J could hurt the frms stoc& price.
4,24 a4 (ndustry
.irm Average
+urrent ratio F
s liabilitie +urrent
assets +urrent
F
G???
G>@>
F 3.H> 3
assets total
to !ebt
F
assets 0otal
!ebt
F
G,A@
G?>A
F >@.@@M
>@.@@
M
earned
interest 0imes
F
(nterest
E8(0
F
G,.A
G,N.A
F ?? H
coverage
E8(0!A
F
pymts
Lease
pymts
"rinc.
(C0
pymts Lease E8(0!A
+ +
+
F
A . J G
A . J? G
F N.,J N
turnover
(nventory
F
s (nventorie
ales
F
G?AN
GHNA
F A ?@
!* F
A >J alesK
receivable Accounts
F
GHNAK>JA
GJJ
F
>@.>
days
3,
days
turnover
A. ..
F
assets fxed Cet
ales
F
G?,H
GHNA
F A.,? J
turnover
A. 0.
F
assets 0otal
ales
F
G,A@
GHNA
F ?.HH >
"roft margin F
ales
income Cet
F
GHNA
G3H
F >.,@M >.@@M
assets total
on )eturn
F
assets 0otal
income Cet
F
G,A@
G3H
F J.@@M N.@@M
)3 Answers and Solutions Chapter 4: Analysis of Financial Statements
e#uity common
on )eturn
F
)*A E4
F JM ?.,3LJ F [Link]
?3.N@
M
Alternatively, )*E F
E#uity
income Cet
F
G>?A
G3H
F [Link] [Link].
b4 )*EF "roft margin 0otal assets turnover E#uity multiplier
F
ales
income Cet

assets 0otal
ales

e#uity +ommon
assets 0otal
F
GHNA
G3H

G,A@
GHNA

G>?A
G,A@
F >.,M ?.HH ?.,3LJ F [Link].
.irm (ndustry +omment
"roft margin >.,M >.@M :ood
0otal assets turnover ?.HH >.@ "oor
E#uity multiplier ?.,3LJ ?.,>P *.O.
P ? E
0A
!
F
0A
E
? E @.>@ F @.H
E4 F
E
0A
F
H . @
?
F ?.,>.
Alternatively, E4 F )*EK)*A F ?[Link] F ?.,>.
c4 Analysis of the extended !u "ont e#uation and the set of ratios shows that the
turnover ratio of sales to assets is #uite low. Either sales should be higher given the
present level of assets, or the frm is carrying more assets than it needs to support its
sales.
-4 0he comparison of inventory turnover ratios shows that other frms in the industry
seem to be getting along with about half as much inventory per unit of sales as the
frm. (f the companys inventory could be reduced, this would generate funds that
could be used to retire debt, thus reducing interest charges and improving profts,
and strengthening the debt position. 0here might also be some excess investment in
fxed assets, perhaps indicative of excess capacity, as shown by a slightly lower/than/
average fxed assets turnover ratio. Rowever, this is not nearly as clear/cut as the
overinvestment in inventory.
e4 (f the frm had a sharp seasonal sales pattern, or if it grew rapidly during the year,
many ratios might be distorted. )atios involving cash, receivables, inventories,
and current liabilities, as well as those based on sales, profts, and common
e#uity, could be biased. (t is possible to correct for such problems by using
average rather than end/of/period fgures.
Chapter 4: Analysis of Financial Statements Answers and Solutions )7
Comprehensive8Sprea-sheet $roblem
Note to Instructors:
%he solution to this problem is not provi-e- to stu-ents at the bac6 of their te9t4
:nstructors can access the Excel ;le on the te9tboo6<s =eb site or the :nstructor<s
'esource C4
4,2(
a4 +orriganSs li#uidity position has improved from 3@@, to 3@@A5 however, its current
ratio is still below the industry average of 3.H.
b4 +orriganSs inventory turnover, fxed assets turnover, and total assets turnover have
improved from 3@@, to 3@@A5 however, they are still below industry averages. 0he
frmSs days sales outstanding has increased from 3@@, to 3@@A9which is bad. (n
3@@,, its !* was close to the industry average. (n 3@@A, its !* is somewhat
higher. (f the frmSs credit policy has not changed, it needs to loo& at its receivables
and determine whether it has any uncollectibles. (f it does have uncollectible
receivables, this will ma&e its current ratio loo& worse than what was calculated
above.
c4 +orriganSs debt ratio has increased from 3@@, to 3@@A, which is bad. (n 3@@,, its
debt ratio was right at the industry average, but in 3@@A it is higher than the industry
average. :iven its wea& current and asset management ratios, the frm should
strengthen its balance sheet by paying down liabilities.
)) ComprehensiveSpreadsheet !roblem Chapter 4: Analysis of Financial
Statements
-4 +orriganSs proftability ratios have declined substantially from 3@@, to 3@@A, and they
are substantially below the industry averages. +orrigan needs to reduce its costs,
increase sales, or both.
e4 +orriganSs "KE ratio has increased from 3@@, to 3@@A, but only because its net
income has declined signifcantly from the prior year. (ts "K+. ratio has declined from
the prior year and is well below the industry average. 0hese ratios re;ect the same
information as +orriganSs proftability ratios. +orrigan needs to reduce costs to
increase proft, lower its debt ratio, increase sales, and improve its asset
management.
f4
Loo&ing at the extended !u "ont e#uation, +orriganSs proft margin is signifcantly
lower than the industry average and it has declined substantially from 3@@, to 3@@A.
0he frmSs total assets turnover has improved slightly from 3@@, to 3@@A, but itSs still
below the industry average. 0he frmSs e#uity multiplier has increased from 3@@, to
3@@A and is higher than the industry average. 0his indicates that the frmSs debt
ratio is increasing and it is higher than the industry average.
+orrigan should increase its net income by reducing costs, lower its debt ratio,
and improve its asset management by either using less assets for the same amount
of sales or increase sales.
g4 (f +orrigan initiated cost/cutting measures, this would increase its net income. 0his
would improve its proftability ratios and mar&et value ratios. (f +orrigan also
reduced its levels of inventory, this would improve its current ratio9as this would
reduce liabilities as well. 0his would also improve its inventory turnover and total
assets turnover ratio. )educing costs and lowering inventory would also improve its
debt ratio.
Chapter 4: Analysis of Financial Statements Answers and Solutions )5
:ntegrate- Case
4,23
<Leon :nc4> $art ::
"inancial Statement Anal#sis
$art : of this case> presente- in Chapter 3> -iscusse- the situation
that <Leon :nc4> a regional snac6,foo-s pro-ucer> /as in after an
e9pansion program4 <Leon ha- increase- plant capacity an-
un-erta6en a major mar6eting campaign in an attempt to ?go
national4@ %hus far> sales have not been up to the forecaste- level>
costs have been higher than /ere projecte-> an- a large loss occurre-
in 2++( rather than the e9pecte- pro;t4 As a result> its managers>
-irectors> an- investors are concerne- about the ;rm<s survival4
onna Aamison /as brought in as assistant to Fre- Campo>
<Leon<s chairman> /ho ha- the tas6 of getting the company bac6 into
a soun- ;nancial position4 <Leon<s 2++4 an- 2++( balance sheets
an- income statements> together /ith projections for 2++3> are given
in %ables :C 4,1 an- :C 4,24 :n a--ition> %able :C 4,3 gives the
company<s 2++4 an- 2++( ;nancial ratios> together /ith in-ustry
average -ata4 %he 2++3 projecte- ;nancial statement -ata represent
Aamison<s an- Campo<s best guess for 2++3 results> assuming that
some ne/ ;nancing is arrange- to get the company ?over the hump4@
Aamison e9amine- monthly -ata for 2++( *not given in the case.>
an- she -etecte- an improving pattern -uring the year4 Bonthly sales
/ere rising> costs /ere falling> an- large losses in the early months
ha- turne- to a small pro;t by ecember4 %hus> the annual -ata loo6
some/hat /orse than ;nal monthly -ata4 Also> it appears to be
ta6ing longer for the a-vertising program to get the message across>
for the ne/ sales oCces to generate sales> an- for the ne/
5+ Integrated Case Chapter 4: Analysis of Financial Statements
manufacturing facilities to operate eCciently4 :n other /or-s> the lags
bet/een spen-ing money an- -eriving bene;ts /ere longer than
<Leon<s managers ha- anticipate-4 For these reasons> Aamison an-
Campo see hope for the companyDprovi-e- it can survive in the short
run4
Aamison must prepare an analysis of /here the company is no/>
/hat it must -o to regain its ;nancial health> an- /hat actions shoul-
be ta6en4 !our assignment is to help her ans/er the follo/ing
7uestions4 $rovi-e clear e9planations> not yes or no ans/ers4
%able :C 4,14 Ealance Sheets
2++3& 2++( 2++4
Assets
Cash F )(>332 F 7>2)2 F (7>3++
Accounts receivable )7)>+++ 332>13+ 3(1>2++
:nventories 1>713>4)+ 1>2)7>33+ 71(>2++
%otal current assets F2>3)+>112 F1>523>)+2 F
1>124>+++
Gross ;9e- assets 1>157>13+ 1>2+2>5(+ 451>+++
Less accumulate- -epreciation 3)+>12+ 233>13+ 143>2++
"et ;9e- assets F )17>+4+ F 535>75+ F 344>)++
%otal assets F 3>457>1(2 F 2>)33>(52 F
1>43)>)++
Liabilities and E$uit#
Accounts payable F 433>)++ F (24>13+ F 14(>3++
"otes payable 3++>+++ 333>)+) 2++>+++
Accruals 4+)>+++ 4)5>3++
133>+++
%otal current liabilities F1>144>)++ F1>3(+>(3) F
4)1>3++
Long,term -ebt 4++>+++ 723>432 323>432
Common stoc6 1>721>173 43+>+++ 43+>+++
'etaine- earnings 231>173 32>(52 2+3>73)
%otal e7uity F 1>5(2>3(2 F 452>(52 F
333>73)
%otal liabilities an- e7uity F 3>457>1(2 F 2>)33>(52 F
1>43)>)++
Chapter 4: Analysis of Financial Statements Integrated Case 51
"ote: ?&@ in-icates estimate-4 %he 2++3 -ata are forecasts4
52 Integrated Case Chapter 4: Analysis of Financial Statements
%able :C 4,24 :ncome Statements
2++3& 2++( 2++4
Sales F7>+3(>3++ F3>+34>+++ F
3>432>+++
Cost of goo-s sol- (>)7(>552 (>(2)>+++
2>)34>+++
Other e9penses ((+>+++ (15>5)) 3()>372
%otal operating costs
e9clu-ing -epreciation F 3>42(>552 F 3>+47>5)) F
3>222>372
&E:%A F 3+5>3+) *F 13>5)). F
2+5>32)
epreciation 113>53+ 113>53+ 1)>5++
&E:% F 452>34) *F 13+>54). F
15+>42)
:nterest e9pense 7+>++) 133>+12 43>)2)
&E% F 422>34+ *F 233>53+. F
143>3++
%a9es *4+H. 135>+(3 *1+3>7)4.
a
()>34+
"et income F 2(3>()4 *F 13+>173. F )7>53+
&$S F 14+14 *F

143+2. F
+4))+
$S F +422+ F +411+ F +422+
Eoo6 value per share F 74)+5 F 44523 F 3433)
Stoc6 price F 12417 F 242( F )4(+
Shares outstan-ing 2(+>+++ 1++>+++ 1++>+++
%a9 rate 4+4++H 4+4++H 4+4++H
Lease payments 4+>+++ 4+>+++ 4+>+++
Sin6ing fun- payments + + +
"ote: ?&@ in-icates estimate-4 %he 2++3 -ata are forecasts4
a
%he ;rm ha- suCcient ta9able income in 2++3 an- 2++4 to obtain its full ta9 refun-
in 2++(4
Chapter 4: Analysis of Financial Statements Integrated Case 53
%able :C 4,34 'atio Analysis
:n-ustry
2++3& 2++( 2++4
Average
Current 142 243 247
0uic6 +44 +4)
14+
:nventory turnover 447 44) 341
ays sales outstan-ing *SO.
a
3)42 3744 324+
Fi9e- assets turnover 344 1+4+ 74+
%otal assets turnover 241 243 243
ebt ratio )24)H (44)H (+4+H
%:& ,14+ 443 342
&E:%A coverage +41 34+ )4+
$ro;t margin ,247H 243H 34(H
Easic earning po/er ,443H 134+H 1541H
'OA ,(43H 34+H 541H
'O& ,324(H 1343H 1)42H
$rice8earnings ,144 547 1442
$rice8cash Io/ ,(42 )4+ 114+
Bar6et8boo6 +4( 143 244
Eoo6 value per share F4453 F3434 n4a4
"ote: ?& in-icates estimate-4 %he 2++3 -ata are forecasts4
a
Calculation is base- on a 33(,-ay year4
A4 =hy are ratios usefulJ =hat are the ;ve major categories of
ratiosJ
Ans/er: KS4,1 through S4,( provi-e bac6groun- information4 %hen>
sho/ S4,3 an- S4,7 here4L 'atios are use- by managers to
help improve the ;rm<s performance> by len-ers to help
evaluate the ;rm<s li6elihoo- of repaying -ebts> an- by
stoc6hol-ers to help forecast future earnings an- -ivi-en-s4
%he ;ve major categories of ratios are: li7ui-ity> asset
management> -ebt management> pro;tability> an- mar6et
value4
54 Integrated Case Chapter 4: Analysis of Financial Statements
E4 Calculate <Leon<s 2++3 current an- 7uic6 ratios base- on
the projecte- balance sheet an- income statement -ata4
=hat can you say about the company<s li7ui-ity positions in
2++4> 2++(> an- as projecte- for 2++3J =e often thin6 of
ratios as being useful *1. to managers to help run the
business> *2. to ban6ers for cre-it analysis> an- *3. to
stoc6hol-ers for stoc6 valuation4 =oul- these -iMerent
types of analysts have an e7ual interest in these li7ui-ity
ratiosJ
Ans/er:KSho/ S4,) an- S4,5 here4L
Current ratio
+3
N Current assets8Current
liabilities
N F2>3)+>1128F1>144>)++ N 24344
0uic6 ratio
+3
N *Current assets O :nventories.8Current
liabilities
N *F2>3)+>112 O F1>713>4)+.8F1>144>)++
N F533>3328F1>144>)++ N +4)424
%he company<s current an- 7uic6 ratios are i-entical to
its 2++4 current an- 7uic6 ratios> an- they have improve-
from their 2++( levels4 #o/ever> both the current an- 7uic6
ratios are /ell belo/ the in-ustry averages4
C4 Calculate the 2++3 inventory turnover> -ays sales outstan-ing
*SO.> ;9e- assets turnover> an- total assets turnover4 #o/
-oes <Leon<s utiliPation of assets stac6 up against other
;rms in its in-ustryJ
Chapter 4: Analysis of Financial Statements Integrated Case 5(
Ans/er: KSho/ S4,1+ through S4,1( here4L
:nventory turnover
+3
N Sales8:nventory
N F7>+3(>3++8F1>713>4)+ N 441+4
SO
+3
N 'eceivables8*Sales833(.
N F)7)>+++8*F7>+3(>3++833(. N 4(4(( -ays4
Fi9e- assets turnover
+3
N Sales8"et ;9e- assets
N F7>+3(>3++8F)17>+4+ N )4314
%otal assets turnover
+3
N Sales8%otal assets
N F7>+3(>3++8F3>457>1(2 N 24+14
%he ;rm<s inventory turnover an- total assets turnover
ratios have been stea-ily -eclining> /hile its -ays sales
outstan-ing has been stea-ily increasing */hich is ba-.4
#o/ever> the ;rm<s 2++3 total assets turnover ratio is only
slightly belo/ the 2++( level4 %he ;rm<s ;9e- assets
turnover ratio is belo/ its 2++4 levelQ ho/ever> it is above
the 2++( level4
%he ;rm<s inventory turnover an- total assets turnover
are belo/ the in-ustry average4 %he ;rm<s -ays sales
outstan-ing is above the in-ustry average */hich is ba-.Q
ho/ever> the ;rm<s ;9e- assets turnover is above the
in-ustry average4 *%his might be -ue to the fact that <Leon
is an ol-er ;rm than most other ;rms in the in-ustry> in
/hich case> its ;9e- assets are ol-er an- thus have been
-epreciate- more> or that <Leon<s cost of ;9e- assets /ere
lo/er than most ;rms in the in-ustry4.
4 Calculate the 2++3 -ebt> times,interest,earne-> an- &E:%A
coverage ratios4 #o/ -oes <Leon compare /ith the in-ustry
53 Integrated Case Chapter 4: Analysis of Financial Statements
/ith respect to ;nancial leverageJ =hat can you conclu-e
from these ratiosJ
Ans/er: KSho/ S4,13 through S4,1) here4L
ebt ratio
+3
N %otal -ebt8%otal assets
N *F1>144>)++ R F4++>+++.8F3>457>1(2 N
44417H4
%:&
+3
N &E:%8:nterest N F452>34)8F7+>++) N 74+44
&E:%A
+3
N

payments
Lease
R &E:%A 8

payments
Lease
R
payments
$rincipal
R :nterest
N *F3+5>3+) R F4+>+++.8*F7+>++) R F4+>+++.
N F345>3+)8F11+>++) N (4514
%he ;rm<s -ebt ratio is much improve- from 2++( an-
2++4> an- it is belo/ the in-ustry average */hich is goo-.4
%he ;rm<s %:& ratio is also greatly improve- from its 2++4
an- 2++( levels an- is above the in-ustry average4 =hile its
&E:%A coverage ratio has improve- from its 2++4 an- 2++(
levels> it is still belo/ the in-ustry average4
&4 Calculate the 2++3 pro;t margin> basic earning po/er *E&$.>
return on assets *'OA.> an- return on e7uity *'O&.4 =hat
can you say about these ratiosJ
Ans/er: KSho/ S4,15 through S4,24 here4L
$ro;t margin
+3
N "et income8Sales
N F2(3>()48F7>+3(>3++ N 343+H4
Easic earning po/er
+3
N &E:%8%otal assets
N F452>34)8F3>457>1(2 N 144+5H4
Chapter 4: Analysis of Financial Statements Integrated Case 57
'OA
+3
N "et income8%otal assets N F2(3>()48F3>457>1(2 N
742(H4
'O&
+3
N "et income8Common e7uity
N F2(3>()48F1>5(2>3(2 N 12455H 134+H4
%he ;rm<s pro;t margin is above 2++4 an- 2++( levels
an- slightly above the in-ustry average4 =hile the ;rm<s
basic earning po/er an- 'OA ratios are above 2++4 an-
2++( levels> they are still belo/ the in-ustry averages4 %he
;rm<s 'O& ratio is greatly improve- over its 2++( levelQ
ho/ever> it is slightly belo/ its 2++4 level an- still /ell
belo/ the in-ustry average4
F4 Calculate the 2++3 price8earnings ratio> price8cash Io/ ratio>
an- mar6et8boo6 ratio4 o these ratios in-icate that
investors are e9pecte- to have a high or lo/ opinion of the
companyJ
Ans/er: KSho/ S4,2( through S4,27 here4L
&$S
+3
N "et income8Shares outstan-ing
N F2(3>()482(+>+++ N F14+1434
$rice8&arnings
+3
N $rice per share8&arnings per share
N F124178F14+143 N 124+4
Chec6: $rice N &$S $8& N F14+143*124+. N F124174
Cash Io/8Share
+3
N *": R ep.8Shares
N *F2(3>()4 R F113>53+.82(+>+++ N
F144)4
$rice8Cash Io/
+3
N F124178F144) N )424
5) Integrated Case Chapter 4: Analysis of Financial Statements
ES$S
+3
N Common e7uity8Shares outstan-ing
N F1>5(2>3(282(+>+++ N F74)14
Bar6et8Eoo6
+3
N Bar6et price per share8Eoo6 value per
share
N F124178F74)1 N 14(34
%he $8&> $8CF> an- B8E ratios are above the 2++( an-
2++4 levels but belo/ the in-ustry average4
G4 Tse the e9ten-e- u $ont e7uation to provi-e a summary
an- overvie/ of <Leon<s ;nancial con-ition as projecte- for
2++34 =hat are the ;rm<s major strengths an- /ea6nessesJ
Ans/er: KSho/ S4,2) an- S4,25 here4L
u $ont e7uation N
margin
$ro;t

turnover
assets %otal

multiplier
&7uity
N 343+H 24+1 18*1 O +44417.
N 12453H 134+H4
Strengths: %he ;rm<s ;9e- assets turnover /as above the
in-ustry average4 #o/ever> if the ;rm<s assets /ere ol-er
than other ;rms in its in-ustry this coul- possibly account
for the higher ratio4 *<Leon<s ;9e- assets /oul- have a
lo/er historical cost an- /oul- have been -epreciate- for
longer perio-s of time4. %he ;rm<s pro;t margin is slightly
above the in-ustry average> an- its -ebt ratio has been
greatly re-uce-> so it is no/ belo/ the in-ustry average
*/hich is goo-.4 %his improve- pro;t margin coul- in-icate
that the ;rm has 6ept operating costs -o/n as /ell as
interest e9pense *as sho/n from the re-uce- -ebt ratio.4
:nterest e9pense is lo/er because the ;rm<s -ebt ratio has
Chapter 4: Analysis of Financial Statements Integrated Case 55
been re-uce-> /hich has improve- the ;rm<s %:& ratio so
that it is no/ above the in-ustry average4
=ea6nesses: %he ;rm<s current asset ratio is lo/Q most of
its asset management ratios are poor *e9cept ;9e- assets
turnover.Q its &E:%A coverage ratio is lo/Q most of its
pro;tability ratios are lo/ *e9cept pro;t margin.Q an- its
mar6et value ratios are lo/4
1++ Integrated Case Chapter 4: Analysis of Financial Statements
#4 Tse the follo/ing simpli;e- 2++3 balance sheet to sho/> in
general terms> ho/ an improvement in the SO /oul- ten-
to aMect the stoc6 price4 For e9ample> if the company coul-
improve its collection proce-ures an- thereby lo/er its SO
from 4(43 -ays to the 32,-ay in-ustry average /ithout
aMecting sales> ho/ /oul- that change ?ripple through@ the
;nancial statements *sho/n in thousan-s belo/. an-
inIuence the stoc6 priceJ
Accounts receivable F )7) ebt F1>(4(
Other current assets 1>)+2
"et ;9e- assets )17 &7uity 1>5(2
%otal assets F3>457 Liabilities plus e7uity
F3>457
Ans/er: KSho/ S4,3+ through S4,33 here4L
Sales per -ay N F7>+3(>3++833( N F15>27(4324
Accounts receivable un-er ne/ policy N F15>27(432
32 -ays
N F313>)2+4
Free- cash N ol- A8' O ne/ A8'
N F)7)>+++ O F313>)2+ N F231>1)+4
'e-ucing accounts receivable an- its SO /ill initially
sho/ up as an a--ition to cash4 %he free- up cash coul- be
use- to repurchase stoc6> e9pan- the business> an- re-uce
-ebt4 All of these actions /oul- li6ely improve the stoc6
price4
:4 oes it appear that inventories coul- be a-juste-> an-> if so>
ho/ shoul- that a-justment aMect <Leon<s pro;tability an-
stoc6 priceJ
Chapter 4: Analysis of Financial Statements Integrated Case 1+1
Ans/er: %he inventory turnover ratio is lo/4 :t appears that the ;rm
either has e9cessive inventory or some of the inventory is
obsolete4 :f inventory /ere re-uce-> this /oul- improve the
current asset ratio> the inventory an- total assets turnover>
an- re-uce the -ebt ratio even further> /hich shoul- improve
the ;rm<s stoc6 price an- pro;tability4
A4 :n 2++(> the company pai- its suppliers much later than the
-ue -ates> an- it /as not maintaining ;nancial ratios at
levels calle- for in its ban6 loan agreements4 %herefore>
suppliers coul- cut the company oM> an- its ban6 coul-
refuse to rene/ the loan /hen it comes -ue in 5+ -ays4 On
the basis of -ata provi-e-> /oul- you> as a cre-it manager>
continue to sell to <Leon on cre-itJ *!ou coul- -eman-
cash on -eliveryDthat is> sell on terms of CODbut that
might cause <Leon to stop buying from your company4.
Similarly> if you /ere the ban6 loan oCcer> /oul- you
recommen- rene/ing the loan or -eman- its repaymentJ
=oul- your actions be inIuence- if> in early 2++3> <Leon
sho/e- you its 2++3 projections plus proof that it /as going
to raise more than F142 million of ne/ e7uityJ
Ans/er: =hile the ;rm<s ratios base- on the projecte- -ata appear to
be improving> the ;rm<s current asset ratio is lo/4 As a
cre-it manager> : /oul- not continue to e9ten- cre-it to the
;rm un-er its current arrangement> particularly if : -i-n<t
have any e9cess capacity4 %erms of CO might be a little
harsh an- might push the ;rm into ban6ruptcy4 Li6e/ise> if
the ban6 -eman-e- repayment this coul- also force the ;rm
into ban6ruptcy4
1+2 Integrated Case Chapter 4: Analysis of Financial Statements
Cre-itors< actions /oul- -e;nitely be inIuence- by an
infusion of e7uity capital in the ;rm4 %his /oul- lo/er the
;rm<s -ebt ratio an- cre-itors< ris6 e9posure4
U4 :n hin-sight> /hat shoul- <Leon have -one bac6 in 2++4J
Ans/er: Eefore the company too6 on its e9pansion plans> it shoul-
have -one an e9tensive ratio analysis to -etermine the
eMects of its propose- e9pansion on the ;rm<s operations4
#a- the ratio analysis been con-ucte-> the company /oul-
have ?gotten its house in or-er@ before un-ergoing the
e9pansion4
L4 =hat are some potential problems an- limitations of
;nancial ratio analysisJ
Ans/er: KSho/ S4,34 an- S4,3( here4L Some potential problems are
liste- belo/:
14 Comparison /ith in-ustry averages is -iCcult if the ;rm
operates many -iMerent -ivisions4
24 iMerent operating an- accounting practices -istort
comparisons4
34 Sometimes har- to tell if a ratio is ?goo-@ or ?ba-4@
44 iCcult to tell /hether company is> on balance> in a
strong or /ea6 position4
(4 ?Average@ performance is not necessarily goo-4
34 Seasonal factors can -istort ratios4
74 ?=in-o/ -ressing@ techni7ues can ma6e statements
an- ratios loo6 better4
Chapter 4: Analysis of Financial Statements Integrated Case 1+3
)4 :nIation has ba-ly -istorte- many ;rms< balance sheets>
so a ratio analysis for one ;rm over time> or a
comparative analysis of ;rms of -iMerent ages> must be
interprete- /ith ju-gment4
B4 =hat are some 7ualitative factors analysts shoul- consi-er
/hen evaluating a company<s li6ely future ;nancial
performanceJ
Ans/er: KSho/ S4,33 here4L %op analysts recogniPe that certain
7ualitative factors must be consi-ere- /hen evaluating a
company4 %hese factors> as summariPe- by the American
Association of :n-ivi-ual :nvestors *AA::.> are as follo/s:
14 Are the company<s revenues tie- to one 6ey customerJ
24 %o /hat e9tent are the company<s revenues tie- to one
6ey pro-uctJ
34 %o /hat e9tent -oes the company rely on a single
supplierJ
44 =hat percentage of the company<s business is
generate- overseasJ
(4 Competition4
34 Future pro-ucts4
74 Legal an- regulatory environment4
1+4 Integrated Case Chapter 4: Analysis of Financial Statements