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Financial Statement Analysis Techniques

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12 views38 pages

Financial Statement Analysis Techniques

Uploaded by

Aoi Yuki
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Chapter 16 Financial Statement Analysis

©Beautiful landscape/Shutterstock

LEARNING OBJECTIVES
After studying Chapter 16, you should be
able to:

LO16-1 Prepare and interpret


financial statements in
comparative and common-
©Sorbis/Shutterstock
size form.

LO16-2 Compute and interpret Under Armour’s Stock Price Plunges


financial ratios that managers
use to assess liquidity. BUSINESS FOCUS
LO16-3 Compute and interpret
Under Armour had reported 26 consecutive quarters of revenue growth
financial ratios that managers
in excess of 20 percent; however, when the company’s revenue growth
use for asset management
rate slowed to 12 percent in a recent quarter, its stock price fell by more
purposes.
than 23 percent. While Under Armour’s quarterly profit was $104.9 million,
LO16-4 Compute and interpret or 23 cents per share, it ended up being less than the $105.6 million
financial ratios that managers in profit earned during the same quarter in the prior year. Furthermore,
use for debt management analysts had expected earnings of 25 cents a share, instead of 23 cents,
purposes. further contributing to the drop in stock price.
Source: Sara Germano and Anne Steele, “Under Armour Plunges After Slip,” The Wall Street Journal, February 1,
LO16-5 Compute and interpret 2017, p. B3.
financial ratios that managers
use to assess profitability.

LO16-6 Compute and interpret


financial ratios that managers
use to assess market
performance.

Data Analytics Exercise available in


Connect to complement this chapter
Financial Statement Analysis 735

S
tockholders, creditors, and managers are examples of stakeholders
that use financial statement analysis to evaluate a company’s financial health and
future prospects. Stockholders and creditors analyze a company’s financial state-
ments to estimate its potential for earnings growth, stock price appreciation, mak-
ing dividend payments, and paying principal and interest on loans. Managers use financial
statement analysis for two reasons. First, it enables them to better understand how their
company’s financial results will be interpreted by stockholders and creditors for the pur-
poses of making investing and lending decisions. Second, financial statement analysis
provides managers with valuable feedback regarding their company’s performance. For
example, managers may study trends in their company’s financial statements to assess
whether performance has been improving or declining. Or, they may use financial state-
ment analysis to benchmark their company’s performance against world-class competitors.
In this chapter, we’ll explain how managers prepare financial statements in compara-
tive and common-size form and how they use financial ratios to assess their company’s
liquidity, asset management, debt management, profitability, and market performance.

Limitations of Financial Statement Analysis


This section discusses two limitations of financial statement analysis that managers
should always keep in mind—comparing financial data across companies and looking
beyond ratios when formulating conclusions.

Comparing Financial Data across Companies


Comparisons of one company with another can provide valuable clues about the finan-
cial health of an organization. Unfortunately, differences in accounting methods between
companies sometimes make it difficult to compare their financial data. For example, if
one company values its inventories by the LIFO method and another company by the aver-
age cost method, then direct comparisons of their financial data such as inventory valu-
ations and cost of goods sold may be misleading. Sometimes enough data are presented
in footnotes to the financial statements to restate data to a comparable basis. Otherwise,
managers should keep in mind any lack of comparability. Even with this limitation in
mind, comparing key ratios with other companies and with industry averages often helps
managers identify opportunities for improvement.

Looking beyond Ratios


Ratios should not be viewed as an end, but rather as a starting point. They raise many
questions and point to opportunities for further analysis, but they rarely answer any ques-
tions by themselves. In addition to financial ratios, managers should consider various
internal factors, such as employee learning and growth, business process performance,
and customer satisfaction as well as external factors like industry trends, technological
changes, changes in consumer tastes, and changes in broad economic indicators.

Statements in Comparative and Common-Size Form


An item on a balance sheet or income statement has little meaning by itself. Suppose a
company’s sales for a year were $250 million. In isolation, that is not particularly useful LO16-1
Prepare and interpret financial
information. How does that stack up against last year’s sales? How do the sales relate to
statements in comparative
the cost of goods sold? In making these kinds of comparisons, three analytical techniques and common-size form.
are widely used:
1. Dollar and percentage changes on statements (horizontal analysis).
2. Common-size statements (vertical analysis).
3. Ratios.
736 Chapter 16

The first and second techniques are discussed in this section; the third technique is dis-
cussed in the remainder of the chapter. Throughout the chapter, we will illustrate these
analytical techniques using the financial statements of Brickey Electronics, a producer of
specialized electronic components.

Dollar and Percentage Changes on Statements


Horizontal analysis (also known as trend analysis) involves analyzing financial data
over time, such as computing year-to-year dollar and percentage changes within a set
of financial statements. Exhibits 16–1 and 16–2 show Brickey Electronics’ financial

EXHIBIT 16–1 Brickey Electronics


Comparative Balance Sheet
(dollars in thousands)
Increase
(Decrease)
This Last
Year Year Amount Percent
Assets
Current assets:
Cash ������������������������������������������������� $ 1,200 $ 2,350 $(1,150)  (48.9)%*
Accounts receivable, net ���������������  6,000  4,000  2,000  50.0%
Inventory �������������������������������������������  8,000  10,000  (2,000)  (20.0)%
Prepaid expenses ���������������������������  300  120  180 150.0%
Total current assets �����������������������������  15,500  16,470  (970)  (5.9)%
Property and equipment:
Land ���������������������������������������������������  4,000  4,000  0  0.0%
Buildings and equipment, net �������  12,000  8,500  3,500  41.2%
Total property and equipment �����������  16,000  12,500  3,500  28.0%
Total assets ������������������������������������������� $31,500 $28,970 $ 2,530  8.7%

Liabilities and Stockholders’ Equity


Current liabilities:
Accounts payable ��������������������������� $ 5,800 $ 4,000 $ 1,800  45.0%
Accrued liabilities ���������������������������  900  400  500 125.0%
Notes payable, short term �������������  300  600  (300)  (50.0)%
Total current liabilities �������������������������  7,000  5,000  2,000  40.0%
Long-term liabilities:
Bonds payable, 8% �������������������������  7,500  8,000  (500)  (6.3)%
Total liabilities ���������������������������������������  14,500  13,000  1,500  11.5%
Stockholders’ equity:
Common stock, $12 par ���������������  6,000  6,000  0  0.0%
Additional paid-in capital ���������������  3,000  3,000  0  0.0%
Total paid-in capital �������������������������  9,000  9,000  0  0.0%
Retained earnings ���������������������������  8,000  6,970  1,030  14.8%
Total stockholders’ equity �����������������  17,000  15,970  1,030  6.4%
Total liabilities and
stockholders’ equity ����������������������� $31,500 $28,970 $ 2,530  8.7%

*The changes between this year and last year are expressed as a percentage of the
dollar amount for last year. For example, Cash decreased by $1,150 between this year
and last year. This decrease expressed in percentage form is computed as follows:
$1,150 ÷ $2,350 = 48.9%. Other percentage figures in this exhibit and Exhibit 16–2
are computed in the same way.
Financial Statement Analysis 737

EXHIBIT 16–2
Brickey Electronics
Comparative Income Statement and Reconciliation of Retained Earnings
(dollars in thousands)
Increase
(Decrease)
This Last
Year Year Amount Percent
Sales ��������������������������������������������������������� $ 52,000 $ 48,000 $4,000  8.3%
Cost of goods sold ���������������������������������  36,000  31,500  4,500  14.3%
Gross margin �������������������������������������������  16,000  16,500  (500) (3.0)%
Selling and administrative expenses:
Selling expenses ���������������������������������  7,000  6,500  500  7.7%
Administrative expenses �������������������  5,860  6,100  (240) (3.9)%
Total selling and administrative
expenses ���������������������������������������������  12,860  12,600  260  2.1%
Net operating income �����������������������������  3,140  3,900  (760) (19.5)%
Interest expense �������������������������������������  640  700  (60) (8.6)%
Net income before taxes �����������������������  2,500  3,200  (700) (21.9)%
Income taxes (30%) ���������������������������������  750  960  (210) (21.9)%
Net income �����������������������������������������������  1,750  2,240 $ (490) (21.9)%
Dividends to common stockholders,
$1.44 per share �������������������������������  720  720
Net income added to retained
earnings �������������������������������������������  1,030  1,520
Beginning retained earnings �����������������  6,970  5,450
Ending retained earnings ����������������������� $ 8,000 $ 6,970

statements in this comparative form. The dollar changes highlight the changes that are
the most important economically; the percentage changes highlight the changes that are
the most unusual.
Horizontal analysis can be even more useful when data from a number of years
are used to compute trend percentages. To compute trend percentages, a base year is
selected and the data for all years are stated as a percentage of that base year. To illustrate,
consider the sales and net income of McDonald’s Corporation, the world’s largest food
service retailer, with more than 37,000 restaurants worldwide:

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sales (millions)������������������ $23,522 $22,745 $24,075 $27,006 $27,567 $28,106 $27,441 $25,413 $24,622 $22,820
Net income (millions) ������ $4,313 $4,551 $4,946 $5,503 $5,465 $5,586 $4,758 $4,529 $4,687 $5,192

By simply looking at these data, you can see that sales increased every year from
2009 through 2013 and then declined every year afterwards. Net income steadily climbed
from 2008 through 2011, plateaued through 2013, declined in 2014 and 2015, and started
to rebound in 2016 and 2017. However, recasting these data into trend percentages aids
interpretation:
738 Chapter 16

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sales������������������������������������� 100% 97% 102% 115% 117% 119% 117% 108% 105% 97%
Net income ������������������������� 100% 106% 115% 128% 127% 130% 110% 105% 109% 120%

In the above table, both sales and net income have been restated as a percentage of the
2008 sales and net income. For example, the 2014 sales of $27,441 are 117% of the 2008
sales of $23,522. This trend analysis is easier to analyze when the data are plotted as in
Exhibit 16–3. McDonald’s experienced constant sales growth from 2009 through 2013 and
then sales declined each year afterwards. Net income grew pretty consistently from 2008
through 2013, plummeted in 2014 and 2015, and resumed an upward trend in 2016 and 2017.

EXHIBIT 16–3 140


McDonald’s Corporation: Trend
Analysis of Sales and Net Income 120

100
Percentage

80

60

40 Sales
Net income
20

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Year

Common-Size Statements
Horizontal analysis, which was discussed in the previous section, examines changes in
financial statement accounts over time. Vertical analysis focuses on the relations among
financial statement accounts at a given point in time. A common-size financial state-
ment is a vertical analysis in which each financial statement account is expressed as
a percentage. In income statements, all items are usually expressed as a percentage of
sales. In balance sheets, all items are usually expressed as a percentage of total assets.
Exhibit 16–4 contains Brickey Electronics’ common-size balance sheet and Exhibit 16–5
­contains its common-size income statement.
Notice from Exhibit 16–4 that placing all assets in common-size form clearly shows
the relative importance of the current assets as compared to the noncurrent assets. It also
shows that significant changes have taken place in the composition of the current assets
over the last year. For example, accounts receivable have increased in relative importance
and both cash and inventory have declined in relative importance. Judging from the sharp
increase in accounts receivable, the deterioration in the cash balance may be a result of an
inability to collect from customers.
The common-size income statement in Exhibit 16–5 states each line item as a per-
centage of sales. For example, the administrative expenses were 12.7 percent of sales
last year and 11.3 percent of sales this year. If the quality and efficiency of Brickey’s
administrative services is holding constant or improving over time, then these two per-
centages suggest that this year Brickey managed its administrative resources more cost-
effectively than last year. Beyond administrative expenses, managers also have a keen
interest in other percentages disclosed in a common-size income statement and those will
be ­discussed in a later section related to profitability ratios.
Financial Statement Analysis 739

EXHIBIT 16–4
Brickey Electronics
Common-Size Comparative Balance Sheet
(dollars in thousands)
Common-Size
Percentages
This Last This Last
Year Year Year Year
Assets
Current assets:
Cash ������������������������������������������������������ $ 1,200 $ 2,350  3.8%*  8.1%
Accounts receivable, net ��������������������  6,000  4,000  19.0%  13.8%
Inventory ������������������������������������������������  8,000  10,000  25.4%  34.5%
Prepaid expenses ��������������������������������  300  120  1.0%  0.4%
Total current assets ����������������������������������  15,500  16,470  49.2%  56.9%
Property and equipment:
Land ��������������������������������������������������������  4,000  4,000  12.7%  13.8%
Buildings and equipment, net ������������  12,000  8,500  38.1%  29.3%
Total property and equipment ����������������  16,000  12,500  50.8%  43.1%
Total assets ������������������������������������������������ $31,500 $28,970 100.0% 100.0%

Liabilities and Stockholders’ Equity


Current liabilities:
Accounts payable �������������������������������� $ 5,800 $ 4,000  18.4%  13.8%
Accrued liabilities ��������������������������������  900  400  2.9%  1.4%
Notes payable, short term ������������������  300  600  1.0%  2.1%
Total current liabilities ������������������������������  7,000  5,000  22.2%  17.3%
Long-term liabilities:
Bonds payable, 8% ������������������������������  7,500  8,000  23.8%  27.6%
Total liabilities ��������������������������������������������  14,500  13,000  46.0%  44.9%
Stockholders’ equity: 
Common stock, $12 par ��������������������  6,000  6,000  19.0%  20.7%
Additional paid-in capital ��������������������  3,000  3,000  9.5%  10.4%
Total paid-in capital ������������������������������  9,000  9,000  28.6%  31.1%
Retained earnings ��������������������������������  8,000  6,970  25.4%  24.0%
Total stockholders’ equity ����������������������  17,000  15,970  54.0%  55.1%
Total liabilities and stockholders’
equity ������������������������������������������������������ $31,500 $28,970 100.0% 100.0%

*Each asset account on a common-size statement is expressed as a percentage of


total assets, and each liability and equity account is expressed as a percentage of
total liabilities and stockholders’ equity. For example, the percentage figure above
for this year’s Cash balance is computed as follows: $1,200 ÷ $31,500 = 3.8%. All
common-size percentages have been rounded to one decimal place; therefore, the
figures as shown may not fully reconcile down each column.
740 Chapter 16

EXHIBIT 16–5
Brickey Electronics
Common-Size Comparative Income Statement
(dollars in thousands))
Common-Size
Percentages*
This Last This Last
Year Year Year Year
Sales ���������������������������������������������������� $52,000 $48,000 100.0% 100.0%
Cost of goods sold ����������������������������  36,000  31,500  69.2%  65.6%
Gross margin ��������������������������������������  16,000  16,500  30.8%  34.4%
Selling and administrative expenses:
Selling expenses ����������������������������  7,000  6,500  13.5%  13.5%
Administrative expenses ��������������  5,860  6,100  11.3%  12.7%
Total selling and administrative
expenses ����������������������������������������  12,860  12,600  24.7%  26.3%
Net operating income ������������������������  3,140  3,900  6.0%  8.1%
Interest expense ��������������������������������  640  700  1.2%  1.5%
Net income before taxes ������������������  2,500  3,200  4.8%  6.7%
Income taxes (30%) ����������������������������  750  960  1.4%  2.0%
Net income ������������������������������������������ $ 1,750 $ 2,240  3.4%  4.7%

*Note that the percentage figures for each year are expressed as a percentage of
total sales for the year. For example, the percentage figure for this year’s cost of
goods sold is computed as follows: $36,000 ÷ $52,000 = 69.2%. All common-size
percentages have been rounded to one decimal place; therefore, the figures as
shown may not fully reconcile down each column.

IN BUSINESS
GOPRO CUTS ITS OPERATING EXPENSES
GoPro, an action-camera maker headquartered in San Mateo, California, sold 11 million ­cameras
over a recent two-year period—a 25 percent increase over the prior two years. However, when
the company’s first drone encountered technical problems and a new camera “designed for
a wider base of consumers flopped in its launch” the company had to make some difficult
adjustments. It cut 470 jobs over a six-month span that lowered annual operating expenses to
$585 million. This represents 47 percent of the company’s sales, which is down from operating
expenses that were 70 percent of sales in the prior year.

Source: Dan Gallagher, “GoPro Puts Its Focus on Profitability,” The Wall Street Journal, March 17, 2017, p. B12
©Ververidis Vasilis/Shutterstock

Ratio Analysis—Liquidity
Liquidity refers to how quickly an asset can be converted to cash. Liquid assets can be
LO16-2 converted to cash quickly, whereas ill-liquid assets cannot. Companies need to continu-
Compute and interpret
ously monitor the amount of their liquid assets relative to the amount that they owe short-
financial ratios that managers
use to assess liquidity.
term creditors, such as suppliers. If a company’s liquid assets are not enough to support
timely payments to short-term creditors, this presents an important management problem
that, if not remedied, can lead to bankruptcy.
This section uses Brickey Electronics’ financial statements to explain one measure
and two ratios that managers use to analyze their company’s liquidity and its ability to
Financial Statement Analysis 741

pay short-term creditors. As you proceed through this section, keep in mind that all calcu-
lations are performed for this year rather than last year.

Working Capital
The excess of current assets over current liabilities is known as working capital.

Working capital = Current assets – Current liabilities

The working capital for Brickey Electronics is computed as follows:


Working capital = $15,500,000 − $7,000,000 = $8,500,000
Managers need to interpret working capital from two perspectives. On one hand, if a
company has ample working capital, it provides some assurance that the company can pay
its creditors in full and on time. On the other hand, maintaining large amounts of working
capital isn’t free. Working capital must be financed with long-term debt and equity—
both of which are expensive. Furthermore, a large and growing working ­capital balance
may indicate troubles, such as excessive growth in inventories. Therefore, m
­ anagers often
want to minimize working capital while retaining the ability to pay short-term creditors.

Current Ratio
A company’s working capital is frequently expressed in ratio form. A company’s current
assets divided by its current liabilities is known as the current ratio:

​Current ratio = ​   


  Current assets  ​​
_______________
Current liabilities

For Brickey Electronics, the current ratio is computed as follows:


$15,500,000
​Current ratio = ​ ___________ ​  = 2.21​
$7,000,000
Although widely regarded as a measure of short-term debt-paying ability, the current
ratio must be interpreted with great care. A declining ratio might be a sign of a deterio-
rating financial condition, or it might be the result of eliminating obsolete inventories or
other stagnant current assets. An improving ratio might be the result of stockpiling inven-
tory, or it might indicate an improving financial situation. In short, the current ratio is
useful, but tricky to interpret.
The general rule of thumb calls for a current ratio of at least 2. However, many com-
panies successfully operate with a current ratio below 2. The adequacy of a current ratio
depends heavily on the composition of the assets. For example, as we see in the table
below, both Worthington Corporation and Greystone, Inc., have current ratios of 2. How-
ever, they are not in comparable financial condition. Greystone is more likely to have
difficulty meeting its current financial obligations because almost all of its ­current assets
consist of inventory rather than more liquid assets such as cash and accounts receivable.

Worthington Greystone,
Corporation Inc.
Current assets:
Cash����������������������������������������������� $ 25,000 $ 2,000
Accounts receivable, net �����������  60,000  8,000
Inventory ���������������������������������������  85,000  160,000
Prepaid expenses �����������������������  5,000  5,000
Total current assets (a) ������������������� $175,000 $175,000
Current liabilities (b) ����������������������� $ 87,500 $ 87,500
Current ratio, (a) ÷ (b) ���������������������  2  2
742 Chapter 16

Acid-Test (Quick) Ratio


The acid-test (quick) ratio is a more rigorous test of a company’s ability to meet its
short-term debts than the current ratio. Inventories and prepaid expenses are excluded
from total current assets, leaving only the more liquid (or “quick”) assets to be divided by
current liabilities.

​          
Cash + Marketable  ​
securities + Accounts receivable ​
​Acid-test ratio = ____________________________________________
Current liabilities

The acid-test ratio measures how well a company can meet its obligations without hav-
ing to liquidate or depend too heavily on its inventory. Ideally, each dollar of liabilities
should be backed by at least $1 of quick assets. However, acid-test ratios as low as 0.3 are
common.
The acid-test ratio for Brickey Electronics is computed below:
$1,200,000 + $0 + $6,000,000
_______________________________
​Acid-test ratio =  ​         ​  = 1.03​
$7,000,000
Although Brickey Electronics’ acid-test ratio is within the acceptable range, a
­ anager might be concerned about several trends revealed in the company’s balance
m
sheet. Notice in Exhibit 16–1 that short-term debts are rising, while the cash balance is
declining. Perhaps the lower cash balance is a result of the substantial increase in accounts
receivable. In short, as with the current ratio, the acid-test ratio should be interpreted with
one eye on its basic components.

Ratio Analysis—Asset Management


A company’s assets are funded by lenders and stockholders, both of whom expect those
LO16-3 assets to be deployed efficiently and effectively. In this section, we’ll describe various
Compute and interpret
measures and ratios that managers use to assess their company’s asset management per-
financial ratios that managers
use for asset management
formance. All forthcoming calculations will be performed for this year.
purposes.
Accounts Receivable Turnover
The accounts receivable turnover and average collection period ratios measure how
quickly credit sales are converted into cash. The accounts receivable turnover is com-
puted by dividing sales on account (i.e., credit sales) by the average accounts receivable
balance for the year:

​Accounts receivable turnover = ​    


    Sales on account
______________________________  ​​
Average accounts receivable balance

Assuming that all of Brickey Electronics’ sales were on account, its accounts receiv-
able turnover is computed as follows:
$52,000,000
_________________________
​Accounts receivable turnover =  ​   
    ​  = 10.4​
(​ ​​$6,000,000 + $4,000,000​)​​  / 2
The accounts receivable turnover can then be divided into 365 days to determine the
average number of days required to collect an account (known as the average collection
period).

365 days
​Average collection period = ​ ________________________
  
    ​​
Accounts receivable turnover
Financial Statement Analysis 743

The average collection period for Brickey Electronics is computed as follows:


365 days
​Average collection period = ________
​   ​= 35.1 days​
10.4
This means that on average it takes 35 days to collect a credit sale. Whether this is
good or bad depends on the credit terms Brickey Electronics is offering its customers.
Many customers will tend to withhold payment for as long as the credit terms allow.
If the credit terms are 30 days, then a 35-day average collection period would usually
be viewed as very good. On the other hand, if the company’s credit terms are 10 days,
then a 35-day average collection period is worrisome. A long collection period may
result from having too many old uncollectible accounts, failing to bill promptly or
­follow up on late accounts, lax credit checks, and so on. In practice, average collec-
tion periods ranging all the way from 10 days to 180 days are common, depending on
the industry.

Inventory Turnover
The inventory turnover ratio measures how many times a company’s inventory has
been sold and replaced during the year. It is computed by dividing the cost of goods
sold by the average level of inventory [(Beginning inventory balance + Ending inventory
­balance) ÷ 2]:

Cost of goods sold


______________________
​Inventory turnover = ​   
    ​​
Average inventory balance

Brickey’s inventory turnover is computed as follows:


$36,000,000
__________________________
​Inventory turnover =  ​   
    ​  = 4.0​
​(​​$8,000,000 + $10,000,000​)​​  / 2
The number of days needed on average to sell the entire inventory (called the a­ verage
sale period) can be computed by dividing 365 by the inventory turnover:

365 days
​​Average sale period​  =​  ​ ________________
   ​​​
  
Inventory turnover

365 days
​= ​ ________ ​ = 91.3 days​
4 times
The average sale period varies from industry to industry. Grocery stores, with sig-
nificant perishable stocks, tend to turn over their inventory quickly. On the other hand,
jewelry stores tend to turn over their inventory slowly. In practice, average sale periods of
10 days to 90 days are common, depending on the industry.
A company whose inventory turnover ratio is much slower than the average for
its industry may have too much inventory or the wrong sorts of inventory. Some man-
agers argue that they must buy in large quantities to take advantage of quantity dis-
counts. But these discounts must be compared to the added costs of insurance, taxes,
financing, and risks of obsolescence and deterioration that result from carrying added
inventories.

Operating Cycle
The operating cycle measures the elapsed time from when inventory is received from
suppliers to when cash is received from customers. It is computed as follows:

Operating cycle = Average sale period + Average collection period


744 Chapter 16

Brickey Electronics’ operating cycle is computed as follows:

​Operating cycle = 91.3 days + 35.1 days = 126.4 days​

A manager’s goal is to reduce the operating cycle because it puts cash receipts in the
company’s possession sooner. In fact, if a company can shrink its operating cycle to fewer
days than its average payment period for suppliers, it means the company is receiving
cash from customers before it has to pay suppliers for inventory purchases. For example,
if a company’s operating cycle is 10 days and its average payment period to suppliers is
30 days, the company is receiving cash from customers 20 days before it pays its suppli-
ers. In this example, the company could earn interest income on cash collections for 20
days before paying a portion of those receipts to suppliers. Conversely, if a company’s
operating cycle is much longer than its average payment period for suppliers, it creates
the need to borrow money to fund its inventories and accounts receivable. In the case of
Brickey Electronics, its operating cycle is very high, thereby suggesting that it needs to
borrow money to fund its working capital.

Total Asset Turnover


The total asset turnover is a ratio that compares total sales to average total assets. It
measures how efficiently a company’s assets are being used to generate sales. This ratio
expands beyond current assets to include noncurrent assets, such as property, plant, and
equipment. It is computed as follows:

   Sales
​Total asset turnover =  ​ _________________  ​​
Average total assets

Brickey Electronics’ total asset turnover is computed as follows:


$52,000,000
__________________________
​Total asset turnover = ​   
    ​ = 1.72​
($31,500,000 + $28,970,000) / 2
A company’s goal is to increase its total asset turnover. To do so, it must either
increase sales or reduce its investment in assets. If a company’s accounts receivable turn-
over and inventory turnover are increasing, but its total asset turnover is decreasing, it
suggests the problem may relate to noncurrent asset utilization and efficiency. It also
bears emphasizing that if all else holds constant, a company’s total asset turnover will
increase over time simply because the accumulated depreciation on plant and equipment
grows over time.

Ratio Analysis—Debt Management


Managers need to evaluate their company’s debt management choices from the vantage
LO16-4 point of two stakeholders—long-term creditors and common stockholders. Long-term
Compute and interpret
creditors are concerned with a company’s ability to repay its loans over the long-run.
financial ratios that managers
use for debt management
For example, if a company paid out all of its available cash in the form of dividends,
purposes. then nothing would be left to pay back creditors. Consequently, creditors often seek
protection by requiring that borrowers agree to various restrictive covenants, or rules.
These restrictive covenants typically include restrictions on dividend payments as well
as rules stating that the company must maintain certain financial ratios at specified
levels. Although restrictive covenants are widely used, they do not ensure that creditors
will be paid when loans come due. The company still must generate sufficient earnings
to cover payments.
Stockholders look at debt from a financial leverage perspective. Financial ­leverage
refers to borrowing money to acquire assets in an effort to increase sales and profits.
Financial Statement Analysis 745

A company can have either positive or negative financial leverage depending on the dif-
ference between its rate of return on total assets and the rate of return that it must pay
its creditors. If the company’s rate of return on total assets exceeds the rate of return the
company pays its creditors, financial leverage is positive. If the rate of return on total
assets is less than the rate of return the company pays its creditors, financial leverage is
negative. We will explore whether Brickey Electronics has positive or negative financial
leverage later in the chapter. For now, you need to understand that if a company has
positive financial leverage, having debt can substantially benefit common stockholders.
Conversely, if a company has negative financial leverage, common stockholders suffer.
Given the potential benefits of maintaining positive financial leverage, managers do not
try to avoid debt, rather they often seek to maintain a level of debt that is considered to be
normal within their industry.
In this section, we explain three ratios that managers use for debt management pur-
poses, times interest earned ratio, debt-to-equity ratio, and the equity multiplier. All cal-
culations are performed for this year.

Times Interest Earned Ratio


The most common measure of a company’s ability to provide protection to its long-term
creditors is the times interest earned ratio. It is computed by dividing earnings before
interest expense and income taxes (i.e., net operating income) by interest expense:

Earnings before interest expense and income taxes


​Times interest earned ratio = ​ _________________________________________
          ​​
Interest expense

For Brickey Electronics, the times interest earned ratio for this year is computed as
follows:
$3,140,000
​Times interest earned =  ​ __________ ​  = 4.91​
$640,000
The times interest earned ratio is based on earnings before interest expense and
income taxes because that is the amount of earnings that is available for making interest
payments. Interest expenses are deducted before income taxes are determined; creditors
have first claim on the earnings before taxes are paid.
A times interest earned ratio of less than 1 is inadequate because interest expense
exceeds the earnings that are available for paying that interest. In contrast, a times inter-
est earned ratio of 2 or more may be considered sufficient to protect long-term creditors.

Debt-to-Equity Ratio
The debt-to-equity ratio is one type of leverage ratio that indicates the relative
­proportions of debt and equity at one point in time on a company’s balance sheet. As
the ­debt-to-equity ratio increases, it indicates that a company is increasing its financial
­leverage. In other words, it is relying on a greater proportion of debt rather than equity to
fund its assets. The debt-to-equity ratio is measured as follows:

​Debt-to-equity-ratio = ​    Total liabilities


_________________
   ​​
Stockholders’ equity

Brickey’s debt-to-equity ratio for this year is computed as follows:


$14,500,000
​Debt-to-equity ratio = ​ ___________ ​ = 0.85​
$17,000,000
At the end of this year, Brickey Electronics’ creditors were providing 85 cents for
each $1 being provided by stockholders.
746 Chapter 16

Creditors and stockholders have different views about the optimal debt-to-equity
ratio. Ordinarily, stockholders would like a lot of debt to take advantage of positive finan-
cial leverage. On the other hand, because equity represents the excess of total assets over
total liabilities, and hence a buffer of protection for creditors, creditors would like to see
less debt and more equity. In practice, debt-to-equity ratios from 0.0 (no debt) to 3.0
are common. Generally speaking, in industries with little financial risk, managers main-
tain high debt-to-equity ratios. In industries with more financial risk, managers maintain
lower debt-to-equity ratios.

Equity Multiplier
The equity multiplier is another type of leverage ratio that indicates the portion of a
company’s assets funded by equity. Similar to the debt-to-equity ratio, as the equity mul-
tiplier increases, it indicates that a company is increasing its financial leverage. In other
words, it is relying on a greater proportion of debt rather than equity to fund its assets.
Instead of measuring amounts in the numerator and denominator at one point in time (as
is done with the debt-to-equity ratio), the equity multiplier focuses on average amounts
maintained throughout the year and it is measured as follows:

Average total assets


________________________
​Equity multiplier = ​   
    ​​
Average stockholders’ equity

Brickey’s equity multiplier for this year is computed as follows:


($31,500,000 + $28,970,000) / 2
__________________________
​Equity multiplier = ​      ​ = 1.83​
($17,000,000 + $15,970,000) / 2
The debt-to-equity ratio and the equity multiplier provide signals about how a
company is managing its mix of debt and equity. We have introduced the equity multi-
plier because it will be used in the next section of the chapter to provide further insight
into how companies measure and interpret what will be defined as return on equity
(ROE).

Ratio Analysis—Profitability
Managers pay close attention to the amount of profits that their companies earn. How-
LO16-5 ever, when analyzing ratios, they tend to focus on the amount of profit earned relative to
Compute and interpret
some other amount such as sales, total assets, or total stockholder’s equity. When profits
financial ratios that managers
use to assess profitability.
are stated as a percentage of another number, such as sales, it helps managers draw
informed conclusions about how the organization is performing over time. For example,
if a company had profits in Years 1 and 2 of $10 and $20, respectively, it would be naïve
to immediately assume that the company’s performance has improved. In other words, if
we further assume that sales in Year 1 are $100 and sales in Year 2 are $1,000, it would
be troubling to see that the company converted $900 of additional sales into only
$10 ­dollars of additional profit. In this section, we develop this idea further by discussing
four profitability ratios commonly used by managers—gross margin percentage, net
profit margin percentage, return on total assets, and return on equity. All forthcoming
calculations are performed for this year.

Gross Margin Percentage


Exhibit 16–5 shows that Brickey’s cost of goods sold as a percentage of sales increased
from 65.6 percent last year to 69.2 percent this year. Or looking at this from a different
viewpoint, the gross margin percentage declined from 34.4 percent last year to 30.8 percent
Financial Statement Analysis 747

this year. Managers and investors pay close attention to this measure of profitability. The
gross margin percentage is computed as follows:

Gross margin
___________
​Gross margin percentage = ​     ​​
Sales

The gross margin percentage should be more stable for retailing companies than for
other companies because the cost of goods sold in retailing excludes fixed costs. When
fixed costs are included in the cost of goods sold, the gross margin percentage should
increase and decrease with sales volume. With increases in sales volume, fixed costs are
spread across more units and the gross margin percentage should improve.

IN BUSINESS
HAS ABERCROMBIE & FITCH LOST ITS CACHET?
Over the past five years, Abercrombie & Fitch (A&F) has earned gross margin percentages in
the low-to-mid 60% range, whereas American Eagle Outfitters and Aéropostale have earned
gross margin percentages below 40 percent. Part of the reason for A&F’s huge margins has
been its strong brand recognition among teenagers, who were willing to pay high prices for
apparel donning the company’s logo. However, now that the fickle teen market has declared
logos a fashion faux pas, it presents A&F with an interesting challenge—maintaining its margins
by selling logo-less apparel. The financial stakes are high given that each 1 percent drop in the
company’s gross margin percentage translates to a 14 percent drop in net operating income.

Source: Miriam Gottfried, “Abercrombie’s Margins Aren’t Cool,” The Wall Street Journal, December 9, 2014, p. C10.

Net Profit Margin Percentage


Exhibit 16–5 shows that Brickey’s net profit margin percentage decreased from
4.7 ­percent last year to 3.4 percent this year. The net profit margin percentage is widely
used by managers and it is computed as follows:

Net income
​​Net profit margin percentage = ​ __________​​
 ​
Sales

The gross profit margin percentage and the net profit margin percentage state the
gross margin and net income as a percentage of sales. The gross margin percentage
focuses on only one type of expense (cost of goods sold) and its impact on performance,
whereas the net profit margin percentage also looks at how selling and administrative
expenses, interest expense, and income tax expense have influenced performance. The
remaining ratios in this section look at profitability relative to amounts reported on the
balance sheet rather than sales.

IN BUSINESS
DROPBOX FILES ITS FIRST PUBLIC FINANCIAL STATEMENTS
When Dropbox filed its first quarterly financial statements as a publicly traded company, its rev-
enues of $316.3 million had jumped 28 percent compared to the same quarter from the prior
year. However, the company’s operating expenses were 209 percent of sales, resulting in a net
loss of $465.5 million.
Dropbox raised $756 million in its initial public offering (IPO) and has yet to show a profit
since its founding in 2007. Nonetheless, many investors remain intrigued by the company’s
growth prospects given Dropbox’s assertion that it has “more than 500 million registered users
of both its free and paid services.”

Source: Jay Greene, “Dropbox Revenue Jumps by 28%,” The Wall Street Journal, May 11, 2018, p. B4. ©Primakov/Shutterstock
748 Chapter 16

Return on Total Assets


The return on total assets is a measure of operating performance that is defined as
follows:

Net income + [Interest expense × (1 − Tax rate)]


​Return on total assets = ​ ________________________________________
          ​​
Average total assets

Interest expense is added back to net income to show what earnings would have been
if the company had no debt. With this adjustment, a manager can evaluate his company’s
return on total assets over time without the analysis being influenced by changes in the
company’s mix of debt and equity over time. Furthermore, this adjustment enables man-
agers to draw more meaningful comparisons with other companies that have differing
amounts of debt. Notice that the interest expense is placed on an after-tax basis by multi-
plying it by the factor (1 − Tax rate).
The return on total assets for Brickey Electronics is computed as follows (from
Exhibits 16–1 and 16–2):
$1,750,000 + [$640,000 × (1 − 0.30)]
_______________________________
​Return on total assets = ​    
     ​= 7.3%​
($31,500,000 + $28,970,000)/2
Brickey Electronics has earned a return of 7.3 percent on average total assets
employed during this year.

Return on Equity
The return on total assets looks at profits relative to total assets, whereas the return on
equity looks at profits relative to the book value of stockholders’ equity. The return on
equity is computed as follows:

​Return on equity = ​   


    ​​
Net income
________________________
Average stockholders’ equity

Brickey Electronics’ return on equity for this year would be computed as follows:
$1,750,000
__________________________
​Return on equity = ​   
    ​ = 10.6%​
($17,000,000 + $15,970,000)/2
Now that we have computed return on total assets and return on equity, we can take
a moment to see financial leverage in operation for Brickey Electronics. Notice from
Exhibit 16–1 that the company pays 8 percent interest on its bonds payable. The after-tax
interest cost of these bonds is only 5.6 percent [8% interest rate × (1 − 0.30) = 5.6%]. As
shown earlier, the company’s after-tax return on total assets is 7.3 percent. Because the
return on total assets of 7.3 percent is greater than the 5.6 percent after-tax interest cost of
the bonds, leverage is positive and the difference goes to the stockholders. This explains
in part why the return on equity of 10.6 percent is greater than the return on total assets
of 7.3 percent.
It also bears emphasizing that many managers and investors take a more in-depth
look at return on equity using principles pioneered by E.I. du Pont de Nemours and
Company (better known as DuPont). This approach recognizes that return on equity is
influenced by three elements—operating efficiency (as measured by net profit margin
percentage), asset usage efficiency (as measured by total asset turnover), and finan-
cial leverage (as measured by the equity multiplier). The following equation computes
Brickey Electronics’ return on equity using these three elements:

Net profit margin Total asset Equity


​Return on equity = ​     ​ × ​
​  ​ ​× ​  ​ ​​
percentage turnover multiplier
Financial Statement Analysis 749

Net income Sales Average total assets


​Return on equity = ​ __________
 ​  × ​ ________________
   ________________________
 ​  × ​   
    ​​
Sales Average total assets Average stockholders’ equity
Return on equity = 3.37% × 1.72 × 1.83 = 10.6%

Notice that the sales and average total asset figures cancel, so we are left with net
income divided by average stockholders’ equity. While this equation is a little bit more
complex, its return on equity of 10.6 percent agrees with the initial return on equity com-
putation performed earlier. Also notice that this equation uses a net profit margin percent-
age of 3.37 percent rather than the rounded net profit margin percentage of 3.4 percent
shown in Exhibit 16–5. The total asset turnover of 1.72 and the equity multiplier of 1.83
were previously computed earlier in the chapter.

Ratio Analysis—Market Performance


This section summarizes five ratios that common stockholders use to assess a company’s
performance. Given that common stockholders are the ones who own the company, it logi- LO16–6
Compute and interpret
cally follows that managers should have a thorough understanding of the measures that their
financial ratios that managers
owners will use to judge their performance. All calculations are performed for this year. use to assess market
performance.
Earnings per Share
An investor buys a stock in the hope of realizing a return in the form of either dividends
or future increases in the value of the stock. Because earnings form the basis for dividend
payments and future increases in the value of shares, investors are interested in a com-
pany’s earnings per share.
Earnings per share is computed by dividing net income by the average number of
common shares outstanding during the year.

   
     ​​
Net income
​Earnings per share = ​ _______________________________________
Average number of common shares outstanding

Using the data in Exhibits 16–1 and 16–2, Brickey Electronics’ earnings per share
would be computed as follows:

$1,750,000
_______________________________
​Earnings per share = ​   
    ​ = $3.50 per share​
(500,000 shares* + 500,000 shares)/2

*$6,000,000 total par value ÷ $12 par value per share = 500,000 shares.

IN BUSINESS
BLUE APRON STRUGGLES TO EARN A PROFIT
Blue Apron delivers meal kits that customers assemble in their homes for an average price of
$8.75 per serving. When the company increased its revenue per customer from $236 to $250
and reported a loss of only 17 cents per share, compared to an expected loss of 24 cents per
share, its stock price rose by 9.5 percent to $2.30 per share.
Blue Apron is facing growing competition from numerous other rivals that deliver meal
kits to niche consumers, such as vegans and meat lovers. The company is responding to this
challenge by expanding its sales channels to include selling meal kits through retailers such as
Costco.
©Scott Eisen/Getty Images
Source: Heather Haddon, “Blue Apron to Sell Meal Kits in Costco to Stave Off Rivals,” The Wall Street Journal, May 4, 2018, p. B2.
750 Chapter 16

Price-Earnings Ratio
The price-earnings ratio expresses the relationship between a stock’s market price per
share and its earnings per share. If we assume that Brickey Electronics’ stock has a mar-
ket price of $40 per share at the end of this year, then its price-earnings ratio would be
computed as follows:

Market price per share


___________________
​Price-earnings ratio = ​       ​​
Earnings per share

$40 per share


​= ​ _____________
  
   ​ = 11.43​
$3.50 per share

The price-earnings ratio is 11.43; that is, the stock is selling for about 11.43 times its
current earnings per share.
A high price-earnings ratio means that investors are willing to pay a premium for
the company’s stock—presumably because the company is expected to have higher than
average future earnings growth. Conversely, if investors believe a company’s future earn-
ings growth prospects are limited, the company’s price-earnings ratio would be relatively
low. In the late 1990s, the stock prices of some [Link] companies—particularly those
with little or no earnings—were selling at levels that resulted in huge and nearly unprec-
edented price-earnings ratios. Many commentators cautioned that these price-earnings
ratios were unsustainable in the long run—and they were right. The stock prices of almost
all [Link] companies subsequently crashed.

Dividend Payout and Yield Ratios


Investors in a company’s stock make money in two ways—increases in the market value
of the stock and dividends. In general, earnings should be retained in a company and not
paid out in dividends as long as the rate of return on funds invested inside the company
exceeds the rate of return that stockholders could earn on alternative investments outside
the company. Therefore, companies with excellent prospects of profitable growth often
pay little or no dividend. Companies with little opportunity for profitable growth, but
with steady, dependable earnings, tend to pay out a higher percentage of their cash flow
from operations as dividends.

The Dividend Payout Ratio The dividend payout ratio quantifies the percentage
of current earnings being paid out in dividends. This ratio is computed by dividing the
dividends per share by the earnings per share for common stock:

Dividends per share


​Dividend payout ratio = ​ _________________
  
   ​​
Earnings per share

For Brickey Electronics, the dividend payout ratio is computed as follows:

$1.44 per share (see Exhibit 15–2)


​Dividend payout ratio = ​ ____________________________
        ​ = 41.1%​
$3.50 per share

There is no such thing as a “right” dividend payout ratio, although the ratio
tends to be similar for companies within the same industry. As noted above, compa-
nies with ample growth opportunities at high rates of return tend to have low payout
ratios, whereas companies with limited reinvestment opportunities tend to have higher
payout ratios.
Financial Statement Analysis 751

The Dividend Yield Ratio The dividend yield ratio is computed by dividing the cur-
rent dividends per share by the current market price per share:

Dividends per share


___________________
​Dividend yield ratio = ​   
   ​​
Market price per share

Because the market price for Brickey Electronics’ stock is $40 per share, the divi-
dend yield is computed as follows:
$1.44 per share
​Dividend yield ratio = ​ _____________
  
   ​ = 3.6%​
$40 per share
The dividend yield ratio measures the rate of return (in the form of cash dividends
only) that would be earned by an investor who buys common stock at the current market
price. A low dividend yield ratio is neither bad nor good by itself.

Book Value per Share


Book value per share measures the amount that would be distributed to holders of each
share of common stock if all assets were sold at their balance sheet carrying amounts
(i.e., book values) and if all creditors were paid off. Book value per share is based entirely
on historical costs. The formula for computing it is:

Total stockholders’ equity


​Book value per share = ​ ________________________________
   
     ​​
Number of common shares outstanding

The book value per share of Brickey Electronics’ common stock is computed as
follows:

$17,000,000
​Book value per share = ​ _____________
  
   ​ = $34 per share​
500,000 shares
If this book value is compared with the $40 market value of Brickey Electronics’
stock, then the stock may appear to be overpriced. However, as we discussed earlier, mar-
ket prices reflect expectations about future earnings and dividends, whereas book value
largely reflects the results of events that have occurred in the past. Ordinarily, the market
value of a stock exceeds its book value. For example, in one year, Microsoft’s common
stock often traded at over 4 times its book value, and Coca-Cola’s market value was over
17 times its book value.

Summary of Ratios and Sources of Comparative Ratio Data


Exhibit 16–6 contains a summary of the ratios discussed in this chapter. The formula
for each ratio and a summary comment on each ratio’s significance are included in the
exhibit.
Exhibit 16–7 contains a listing of public sources that provide comparative ratio
data organized by industry. These sources are used extensively by managers, investors,
and analysts. The EDGAR database listed in Exhibit 16–7 is a particularly rich source
of data. It contains copies of all reports filed by companies with the SEC since about
1995—including annual reports filed as Form 10-K.
752 Chapter 16

EXHIBIT 16–6
Summary of Ratios

Ratio Formula Significance


Liquidity:
Working capital Current assets − Current liabilities Measures the company’s ability to repay current
liabilities using only current assets
Current ratio Current assets ÷ Current liabilities Test of short-term debt-paying ability
Acid-test ratio (Cash + Marketable securities + Test of short-term debt-paying ability without
Accounts receivable) ÷ Current having to rely on inventory
liabilities
Asset Management:
Accounts receivable Sales on account ÷ Average accounts Measures how many times a company’s
turnover receivable balance accounts receivable have been turned into
cash during the year
Average collection period 365 days ÷ Accounts receivable Measures the average number of days taken to
turnover collect an account receivable
Inventory turnover Cost of goods sold ÷ Average Measures how many times a company’s
inventory balance inventory has been sold during the year
Average sale period 365 days ÷ Inventory turnover Measures the average number of days taken to
sell the inventory one time
Operating cycle Average sale period + Average Measures the elapsed time from when
collection period inventory is received from suppliers to when
cash is received from customers
Total asset turnover Sales ÷ Average total assets Measures how efficiently assets are being used
to generate sales
Debt Management:
Times interest earned ratio Earnings before interest expense and Measures the company’s ability to make
income taxes ÷ Interest expense interest payments
Debt-to-equity ratio Total liabilities ÷ Stockholders’ equity Measures the amount of assets being provided
by creditors for each dollar of assets being
provided by the stockholders
Equity multiplier Average total assets ÷ Average Measures the portion of a company’s assets
stockholders’ equity funded by equity
Profitability:
Gross margin percentage Gross margin ÷ Sales Measures profitability before selling and
administrative expenses
Net profit margin percentage Net income ÷ Sales A broad measure of profitability
Return on total assets {Net income + [Interest expense × Measures how well assets have been
(1 − Tax rate)]} ÷ Average total assets employed by management
Return on equity Net income ÷ Average stockholders’ When compared to the return on total assets,
equity measures the extent to which financial
leverage is working for or against common
stockholders
Market Performance:
Earnings per share Net income ÷ Average number of Affects the market price per share, as reflected
common shares outstanding in the price-earnings ratio
Price-earnings ratio Market price per share ÷ Earnings per An index of whether a stock is relatively cheap
share or relatively expensive in relation to current
earnings
Dividend payout ratio Dividends per share ÷ Earnings per An index showing whether a company pays out
share most of its earnings in dividends or reinvests
the earnings internally
Dividend yield ratio Dividends per share ÷ Market price Shows the return in terms of cash dividends
per share being provided by a stock
Book value per share Total stockholders’ equity ÷ Number Measures the amount that would be distributed
of common shares outstanding to common stockholders if all assets were
sold at their balance sheet carrying amounts
and if all creditors were paid off
Financial Statement Analysis 753

EXHIBIT 16–7
Sources of Financial Ratios

Source Content

Almanac of Business and Industrial An exhaustive source that contains common-size income statements and
Financial Ratios, Aspen Publish- financial ratios by industry and by the size of companies within each
ers; published annually industry.
AMA Annual Statement Studies, Risk A widely used publication that contains common-size statements and
Management Association; pub- financial ratios on individual companies; the companies are arranged by
lished annually industry.
EDGAR, Securities and Exchange An exhaustive Internet database that contains reports filed by companies with
Commission; website that is con- the SEC; these reports can be downloaded.
tinually updated; [Link]
Hoover’s Online, Hoovers, Inc.; A site that provides capsule profiles for 10,000 U.S. companies with links to
­website that is continually company websites, annual reports, stock charts, news articles, and industry
updated; [Link] information.
Industry Norms & Key Business Fourteen commonly used financial ratios are computed for over 800 major
Ratios, Dun & Bradstreet; pub- industry groupings.
lished annually
Mergent Industrial Manual and Mer- An exhaustive source that contains financial ratios on all companies listed on
gent Bank and Finance Manual; the New York Stock Exchange, the American Stock Exchange, and regional
published annually American exchanges.
Sandard & Poor’s Industry ­Survey, Various statistics, including some financial ratios, are given by industry and for
Standard & Poor’s; published leading companies within each industry grouping.
annually

Summary
The data contained in financial statements represent a quantitative summary of a company’s opera-
tions and activities. A manager who is skillful at analyzing these statements can learn much about
his company’s strengths, weaknesses, emerging problems, operating efficiency, profitability, and
so forth.
Many techniques are available to analyze financial statements and to assess the direction
and importance of trends and changes. In this chapter, we have discussed three such analytical
techniques—dollar and percentage changes in statements (horizontal analysis), common-size
­
statements (vertical analysis), and ratio analysis. Refer to Exhibit 16–6 for a detailed listing of
the ratios.

Data Analytics Exercise available in Connect to complement this chapter

Review Problem: Selected Ratios and Financial Leverage


Mulligan Corporation’s financial statements are as follows:
754 Chapter 16

Mulligan Corporation
Comparative Balance Sheet
(dollars in millions)
This Year Last Year
Assets
Current assets:
Cash ���������������������������������������������������������������������������������� $ 281 $ 313
Marketable securities ������������������������������������������������������  157  141
Accounts receivable ��������������������������������������������������������  288  224
Inventories ������������������������������������������������������������������������  692  636
Other current assets ��������������������������������������������������������  278  216
Total current assets ��������������������������������������������������������������  1,696  1,530
Property and equipment, net ��������������������������������������������  2,890  2,288
Other assets ��������������������������������������������������������������������������  758  611
Total assets ���������������������������������������������������������������������������� $5,344 $4,429

Liabilities and Stockholders’ Equity


Current liabilities:
Accounts payable ������������������������������������������������������������ $ 391 $ 341
Short-term bank loans ����������������������������������������������������  710  700
Accrued liabilities ������������������������������������������������������������  757  662
Other current liabilities ����������������������������������������������������  298  233
Total current liabilities ����������������������������������������������������������  2,156  1,936
Long-term liabilities ��������������������������������������������������������������  904  265
Total liabilities ������������������������������������������������������������������������  3,060  2,201
Stockholders’ equity:
Common stock and additional paid-in capital ������������  40  40
Retained earnings ������������������������������������������������������������  2,244  2,188
Total stockholders’ equity ��������������������������������������������������  2,284  2,228
Total liabilities and stockholders’ equity �������������������������� $5,344 $4,429

Mulligan Corporation
Income Statement
(dollars in millions)
This Year
Sales ����������������������������������������������������������������������� $9,411
Cost of goods sold �����������������������������������������������  3,999
Gross margin ���������������������������������������������������������  5,412
Selling and administrative expenses:
Store operating expenses �������������������������������  3,216
Other operating expenses �������������������������������  294
Depreciation and amortization �����������������������  467
General and administrative expenses �����������  489
Total selling and administrative expenses �������  4,466
Net operating income �������������������������������������������  946
Plus interest and other income ���������������������������  110
Interest expense ���������������������������������������������������  0
Net income before taxes �������������������������������������  1,056
Income taxes (about 36%) �����������������������������������  384
Net income ������������������������������������������������������������� $ 672
Financial Statement Analysis 755

Required:
  1. Compute the return on total assets.
  2. Compute the return on equity.
  3. Is Mulligan’s financial leverage positive or negative? Explain.
  4. Compute the current ratio.
  5. Compute the acid-test ratio.
  6. Compute the inventory turnover.
  7. Compute the average sale period.
  8. Compute the debt-to-equity ratio.
  9. Compute the total asset turnover.
10. Compute the net profit margin percentage.

Solution to Review Problem


1. Return on total assets:
Net income + [Interest expense × (1 − Tax rate)]
________________________________________
Return on total assets =     
​       ​
Average total assets
​​     
​  ​   ​​​
$672 + [$0 × (1 − 0.36)]
_____________________
=    ​      ​ = 13.8% (rounded)
($5,344 + $4,429) / 2
2. Return on equity:

Return on equity =    ​      Net income


________________________  ​
Average stockholders’ equity
​​ ​    
​  ​ ​​
$672
​= _________________
​     ​ = 29.8% (rounded)
($2,284 + $2,228) / 2
3. The company has positive financial leverage because the return on equity of 29.8% is greater
than the return on total assets of 13.8%. The positive financial leverage was obtained from
current and long-term liabilities.
4. Current ratio:

​    Current assets  ​


Current ratio = _______________
  
Current liabilities
​​   
​  ​  ​ ​​
$1,696
= ______
​   ​ = 0.79 (rounded)
$2,156

5. Acid-test ratio:

​  Cash + Marketable securities + Accounts


____________________________________________
Acid-test ratio =            ​ receivable
Current liabilities
​​      
​  ​  ​   ​​​
$281 + $157 + $288
______________________
=    ​      ​ = 0.34 (rounded)
$2,156

6. Inventory turnover:
​Cost of goods sold​
______________________
Inventory turnover =    ​      ​
Average inventory balance
​​    
​  ​  ​ ​​
$3,999
= ______________
​     ​ = 6.0 (rounded)
($692 + $636)/2
7. Average sale period:
365 days
Average sale period = ________________
​   
   ​
Inventory turnover
​​   
​  ​  ​ ​​
365 days
________
= ​   ​= 60.8 days (rounded)
6.0
8. Debt-to-equity ratio:

​   
   Total liabilities  ​
Debt-to-equity ratio = _________________
Stockholders’ equity
​​   
​  ​  ​ ​​
$3,060
= ______
​   ​= 1.34 (rounded)
$2,284
756 Chapter 16

  9. Total asset turnover:

Total asset turnover = ________________


​     Sales  ​
Average total assets
    
​​ ​  ​  ​ ​​
$9,411
_________________
Total asset turnover =    ​     ​= 1.93 (rounded)
($5,344 + $4,429)/2
10. Net profit margin percentage:

​ ​
​  Net income
Net profit margin percentage = ____________  ​
Sales
    
​​ ​  ​  ​ ​​
$672
Net profit margin percentage = ______
​   ​  = 7.1% (rounded)
$9,411

Glossary
(Note: Definitions and formulas for all financial ratios are shown in Exhibit 16–6. These defini-
tions and formulas are not repeated here.)
Acid-test (quick) ratio a more rigorous test of a company’s ability to meet its short-term debts
than the current ratio. Inventories and prepaid expenses are excluded from total current assets,
leaving only the more liquid (or “quick”) assets to be divided by current liabilities (p. 742)
Current ratio A company’s current assets divided by its current liabilities (p. 741)
Common-size financial statements A statement that shows the items appearing on it in
­percentage form as well as in dollar form. On the income statement, the percentages are
based on total sales revenue; on the balance sheet, the percentages are based on total assets.
(p. 738)
Financial leverage A difference between the rate of return on assets and the rate paid to creditors.
(p. 744)
Horizontal analysis A side-by-side comparison of two or more years’ financial statements.
(p. 736)
Liquidity Refers to how quickly an asset can be converted to cash. Liquid assets can be converted
to cash quickly, whereas ill-liquid assets cannot. (p. 740)
Trend analysis See Horizontal analysis. (p. 736)
Trend percentages Several years of financial data expressed as a percentage of performance in a
base year. (p. 737)
Vertical analysis The presentation of a company’s financial statements in common-size form.
(p. 738)
Working capital Current assets less current liabilities. (p. 741)

Questions
®

16–1 Distinguish between horizontal and vertical analysis of financial statement data.
16–2 What is the basic purpose for examining trends in a company’s financial ratios and other
data? What other kinds of comparisons might an analyst make?
16–3 Assume that two companies in the same industry have equal earnings. Why might these
companies have different price-earnings ratios? If a company has a price-earnings ratio
of 20 and reports earnings per share for the current year of $4, at what price would you
expect to find the stock selling on the market?
16–4 Would you expect a company in a rapidly growing technological industry to have a high
or low dividend payout ratio?
16–5 What is meant by the dividend yield on a common stock investment?
16–6 What is meant by the term financial leverage?
Financial Statement Analysis 757

16–7 The president of a plastics company was quoted in a business journal as stating, “We
haven’t had a dollar of interest-paying debt in over 10 years. Not many companies can
say that.” As a stockholder in this company, how would you feel about its policy of not
taking on debt?
16–8 If a stock’s market value exceeds its book value, then the stock is overpriced. Do you
agree? Explain.
16–9 A company seeking a line of credit at a bank was turned down. Among other things, the
bank stated that the company’s 2 to 1 current ratio was not adequate. Give reasons why a
2 to 1 current ratio might not be adequate.

The Foundational 15
®

Markus Company’s common stock sold for $2.75 per share at the end of this year. The company LO16–2, LO16–3, LO16–4,
paid a common stock dividend of $0.55 per share this year. It also provided the following data LO16–5, LO16–6
excerpts from this year’s financial statements:

Ending Balance Beginning Balance


Cash �������������������������������������������������������������� $35,000 $30,000
Accounts receivable ������������������������������������ $60,000 $50,000
Inventory �������������������������������������������������������� $55,000 $60,000
Current assets ���������������������������������������������� $150,000 $140,000
Total assets ���������������������������������������������������� $450,000 $460,000
Current liabilities ������������������������������������������ $60,000 $40,000
Total liabilities ������������������������������������������������ $130,000 $120,000
Common stock, $1 par value �������������������� $120,000 $120,000
Total stockholders’ equity �������������������������� $320,000 $340,000
Total liabilities and stockholders’ equity . . . . $450,000 $460,000

This Year
Sales (all on account)������������������������������������ $700,000
Cost of goods sold���������������������������������������� $400,000
Gross margin�������������������������������������������������� $300,000
Net operating income���������������������������������� $140,000
Interest expense�������������������������������������������� $8,000
Net income ���������������������������������������������������� $92,400

Required:
1. What is the earnings per share?
2. What is the price-earnings ratio?
3. What is the dividend payout ratio and the dividend yield ratio?
4. What is the return on total assets (assuming a 30% tax rate)?
5. What is the return on equity?
6. What is the book value per share at the end of this year?
7. What is the amount of working capital and the current ratio at the end of this year?
8. What is the acid-test ratio at the end of this year?
9. What is the accounts receivable turnover and the average collection period?
10. What is the inventory turnover and the average sale period?
11. What is the company’s operating cycle?
12. What is the total asset turnover?
13. What is the times interest earned ratio?
14. What is the debt-to-equity ratio at the end of this year?
15. What is the equity multiplier?
758 Chapter 16

Exercises
®

EXERCISE 16-1 Common-Size Income Statement LO16–1


A comparative income statement is given below for McKenzie Sales, Ltd., of Toronto:

McKenzie Sales, Ltd.


Comparative Income Statement
This Year Last Year
Sales ������������������������������������������������������������ $8,000,000 $6,000,000
Cost of goods sold ������������������������������������  4,984,000  3,516,000
Gross margin ����������������������������������������������  3,016,000  2,484,000
Selling and administrative expenses:
Selling expenses ������������������������������������  1,480,000  1,092,000
Administrative expenses ����������������������  712,000  618,000
Total expenses ��������������������������������������������  2,192,000  1,710,000
Net operating income ��������������������������������  824,000  774,000
Interest expense ����������������������������������������  96,000  84,000
Net income before taxes �������������������������� $ 728,000 $ 690,000

Members of the company’s board of directors are surprised to see that net income increased by
only $38,000 when sales increased by $2,000,000.
Required:
1. Express each year’s income statement in common-size percentages. Carry computations to
one decimal place.
2. Comment briefly on the changes between the two years.

EXERCISE 16-2 Financial Ratios for Assessing Liquidity LO16–2


Comparative financial statements for Weller Corporation, a merchandising company, for the year
ending December 31 appear below. The company did not issue any new common stock during the
year. A total of 800,000 shares of common stock were outstanding. The interest rate on the bond
payable was 12%, the income tax rate was 40%, and the dividend per share of common stock was
$0.75 last year and $0.40 this year. The market value of the company’s common stock at the end of
this year was $18. All of the company’s sales are on account.

Weller Corporation
Comparative Balance Sheet
(dollars in thousands)
This Year Last Year

Assets
Current assets:
Cash ���������������������������������������������������������������������� $ 1,280 $ 1,560
Accounts receivable, net ��������������������������������  12,300  9,100
Inventory ������������������������������������������������������������  9,700  8,200
Prepaid expenses ��������������������������������������������  1,800  2,100
Total current assets ����������������������������������������������  25,080  20,960
Property and equipment:
Land ��������������������������������������������������������������������  6,000  6,000
Buildings and equipment, net ������������������������  19,200  19,000
Total property and equipment ����������������������������  25,200  25,000
Total assets ������������������������������������������������������������ $50,280 $45,960

(Continued on next page)


Financial Statement Analysis 759

(Continued)
This Year Last Year

Liabilities and Stockholders’ Equity


Current liabilities:
Accounts payable �������������������������������������������� $ 9,500 $ 8,300
Accrued liabilities ��������������������������������������������  600  700
Notes payable, short term ������������������������������  300  300
Total current liabilities ������������������������������������������  10,400  9,300
Long-term liabilities:
Bonds payable ��������������������������������������������������  5,000  5,000
Total liabilities ��������������������������������������������������������  15,400  14,300
Stockholders’ equity:
Common stock �������������������������������������������������  800  800
Additional paid-in capital ��������������������������������  4,200  4,200
Total paid-in capital ����������������������������������������������  5,000  5,000
Retained earnings ������������������������������������������������  29,880  26,660
Total stockholders’ equity ����������������������������������  34,880  31,660
Total liabilities and stockholders’ equity ���������� $50,280 $45,960

Weller Corporation
Comparative Income Statement and Reconciliation
(dollars in thousands)
This Year Last Year
Sales ���������������������������������������������������������������������� $79,000 $74,000
Cost of goods sold ����������������������������������������������  52,000  48,000
Gross margin ��������������������������������������������������������  27,000  26,000
Selling and administrative expenses:
Selling expenses ����������������������������������������������  8,500  8,000
Administrative expenses ��������������������������������  12,000  11,000
Total selling and administrative expenses ������  20,500  19,000
Net operating income ������������������������������������������  6,500  7,000
Interest expense ��������������������������������������������������  600  600
Net income before taxes ������������������������������������  5,900  6,400
Income taxes ��������������������������������������������������������  2,360  2,560
Net income ������������������������������������������������������������  3,540  3,840
Dividends to common stockholders ����������������  320  600
Net income added to retained earnings ����������  3,220  3,240
Beginning retained earnings ������������������������������  26,660  23,420
Ending retained earnings ������������������������������������ $29,880 $26,660

Required:
Compute the following financial data and ratios for this year:
1. Working capital.
2. Current ratio.
3. Acid-test ratio.

EXERCISE 16-3 Financial Ratios for Asset Management LO16–3


Refer to the data in Exercise 16-2 for Weller Corporation.
760 Chapter 16

Required:
Compute the following financial data for this year:
1. Accounts receivable turnover. (Assume that all sales are on account.)
2. Average collection period.
3. Inventory turnover.
4. Average sale period.
5. Operating cycle.
6. Total asset turnover.

EXERCISE 16-4 Financial Ratios for Debt Management LO16–4


Refer to the data in Exercise 16-2 for Weller Corporation.
Required:
Compute the following financial ratios for this year:
1. Times interest earned ratio.
2. Debt-to-equity ratio.
3. Equity multiplier.

EXERCISE 16-5 Financial Ratios for Assessing Profitability LO16–5


Refer to the data in Exercise 16-2 for Weller Corporation.
Required:
Compute the following financial data for this year:
1. Gross margin percentage.
2. Net profit margin percentage.
3. Return on total assets.
4. Return on equity.

EXERCISE 16-6 Financial Ratios for Assessing Market Performance LO16–6


Refer to the data in Exercise 16-2 for Weller Corporation.
Required:
Compute the following financial data for this year:
1. Earnings per share.
2. Price-earnings ratio.
3. Dividend payout ratio.
4. Dividend yield ratio.
5. Book value per share.

EXERCISE 16-7 Trend Percentages LO16–1


Rotorua Products, Ltd., of New Zealand markets agricultural products for the burgeoning Asian
consumer market. The company’s current assets, current liabilities, and sales over the last five
years (Year 5 is the most recent year) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5


Sales ������������������������������������������������������������������� $1,800,000 $1,980,000 $2,070,000 $2,160,000 $2,250,000
Cash ������������������������������������������������������������������� $ 50,000 $ 65,000 $ 48,000 $ 40,000 $ 30,000
Accounts receivable, net ���������������������������������  300,000  345,000  405,000  510,000  570,000
Inventory �������������������������������������������������������������  600,000  660,000  690,000  720,000  750,000
Total current assets ������������������������������������������� $ 950,000 $1,070,000 $1,143,000 $1,270,000 $1,350,000
Current liabilities ����������������������������������������������� $ 400,000 $ 440,000 $ 520,000 $ 580,000 $ 640,000

Required:
1. Express all of the asset, liability, and sales data in trend percentages. (Show percentages for
each item.) Use Year 1 as the base year and carry computations to one decimal place.
2. Comment on the results of your analysis.
Financial Statement Analysis 761

EXERCISE 16-8 Selected Financial Ratios LO16–2, LO16–3, LO16–4


The financial statements for Castile Products, Inc., are given below:

Castile Products, Inc.


Balance Sheet
December 31
Assets
Current assets:
Cash �������������������������������������������������������������������������������������������� $ 6,500
Accounts receivable, net ����������������������������������������������������������  35,000
Merchandise inventory ��������������������������������������������������������������  70,000
Prepaid expenses ����������������������������������������������������������������������  3,500
Total current assets ������������������������������������������������������������������������  115,000
Property and equipment, net ������������������������������������������������������  185,000
Total assets �������������������������������������������������������������������������������������� $300,000

Liabilities and Stockholders’ Equity


Liabilities:
Current liabilities ������������������������������������������������������������������������ $ 50,000
Bonds payable, 10% ������������������������������������������������������������������  80,000
Total liabilities ����������������������������������������������������������������������������������  130,000
Stockholders’ equity: ��������������������������������������������������������������������
Common stock, $5 per value ��������������������������������������������������  30,000
Retained earnings ����������������������������������������������������������������������  140,000
Total stockholders’ equity ������������������������������������������������������������  170,000
Total liabilities and stockholders’ equity ������������������������������������ $300,000

Castile Products, Inc.


Income Statement For the Year Ended
December 31
Sales ������������������������������������������������������������������� $420,000
Cost of goods sold �������������������������������������������  292,500
Gross margin �����������������������������������������������������  127,500
Selling and administrative expenses �������������  89,500
Net operating income ���������������������������������������  38,000
Interest expense �����������������������������������������������  8,000
Net income before taxes ���������������������������������  30,000
Income taxes (30%) �������������������������������������������  9,000
Net income ��������������������������������������������������������� $ 21,000

Account balances at the beginning of the year were: accounts receivable, $25,000; and inventory,
$60,000. All sales were on account.
Required:
Compute the following financial data and ratios:
1. Working capital.
2. Current ratio.
3. Acid-test ratio.
4. Debt-to-equity ratio.
5. Times interest earned ratio.
6. Average collection period.
7. Average sale period.
8. Operating cycle.
762 Chapter 16

EXERCISE 16-9 Financial Ratios for Assessing Profitability and Managing Debt LO16–4, LO16–5
Refer to the financial statements for Castile Products, Inc., in Exercise 16-8. Assets at the begin-
ning of the year totaled $280,000, and the stockholders’ equity totaled $161,600.
Required:
Compute the following:
1. Gross margin percentage.
2. Net profit margin percentage.
3. Return on total assets.
4. Return on equity.
5. Was financial leverage positive or negative for the year? Explain.

EXERCISE 16-10 Financial Ratios for Assessing Market Performance LO16–6


Refer to the financial statements for Castile Products, Inc., in Exercise 16-8. In addition to the data
in these statements, assume that Castile Products, Inc., paid dividends of $2.10 per share during the
year. Also assume that the company’s common stock had a market price of $42 at the end of the year
and there was no change in the number of outstanding shares of common stock during the year.
Required:
Compute financial ratios as follows:
1. Earnings per share.
2. Dividend payout ratio.
3. Dividend yield ratio.
4. Price-earnings ratio.
5. Book value per share.

EXERCISE 16-11 Financial Ratios for Assessing Profitability and Managing Debt LO16–4, LO16–5
Selected financial data from the June 30 year-end statements of Safford Company are given below:

Total assets ������������������������������������������������������ $3,600,000


Long-term debt (12% interest rate) ������������� $500,000
Total stockholders’ equity ���������������������������� $2,400,000
Interest paid on long-term debt ������������������ $60,000
Net income ������������������������������������������������������ $280,000

Total assets at the beginning of the year were $3,000,000; total stockholders’ equity was $2,200,000.
The company’s tax rate is 30%.
Required:
1. Compute the return on total assets.
2. Compute the return on equity.
3. Is financial leverage positive or negative? Explain.

EXERCISE 16-12 Selected Financial Measures for Assessing Liquidity LO16–2


Norsk Optronics, ALS, of Bergen, Norway, had a current ratio of 2.5 on June 30 of the current
year. On that date, the company’s assets were:

Cash ��������������������������������������������������������������� $ 90,000


Accounts receivable, net �����������������������������  260,000
Inventory ���������������������������������������������������������  490,000
Prepaid expenses �����������������������������������������  10,000
Plant and equipment, net �����������������������������  800,000
Total assets ����������������������������������������������������� $1,650,000

Required:
1. What was the company’s working capital on June 30?
2. What was the company’s acid-test ratio on June 30?
3. The company paid an account payable of $40,000 immediately after June 30.
a. What effect did this transaction have on working capital? Show computations.
b. What effect did this transaction have on the current ratio? Show computations.
Financial Statement Analysis 763

Problems
®

PROBLEM 16-13 Effects of Transactions on Various Financial Ratios LO16–2, LO16–3, LO16–4,
LO16–5, LO16–6
In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a busi-
ness transaction or event relating to the operating activities of Delta Company (each transaction
should be considered independently).

Business Transaction or Event Ratio


1.   Declared a cash dividend. Current ratio
2.   Sold inventory on account at cost. Acid-test ratio
3.   Issued bonds with an interest rate of 8%. The company’s return on assets is 10%. Return on equity
4.  Net income decreased by 10% between last year and this year. Long-term debt remained unchanged. Times interest earned
5.   Paid a previously declared cash dividend. Current ratio
6.  The market price of the company’s common stock dropped from $24.50 to $20.00. The dividend Dividend payout ratio
paid per share remained unchanged.
7.   Obsolete inventory totaling $100,000 was written off as a loss. Inventory turnover ratio
8.   Sold inventory for cash at a profit. Debt-to-equity ratio
9.  Changed customer credit terms from 2/10, n/30 to 2/15, n/30 to comply with a change in industry Accounts receivable
practice. turnover ratio
10.   Issued a stock dividend to common stockholders. Book value per share
11.   The market price of the company’s common stock increased from $24.50 to $30.00. Book value per share
12.   Paid $40,000 on accounts payable. Working capital
13.   Issued a stock dividend to common stockholders. Earnings per share
14.   Paid accounts payable. Debt-to-equity ratio
15.   Purchased inventory on account. Acid-test ratio
16.   Wrote off an uncollectible account against the Allowance for Bad Debts. Current ratio
17.  The market price of the company’s common stock increased from $24.50 to $30.00. Earnings per Price-earnings ratio
share remained unchanged.
18.  The market price of the company’s common stock increased from $24.50 to $30.00. The dividend Dividend yield ratio
paid per share remained unchanged.

Required:
Indicate the effect that each business transaction or event would have on the ratio listed opposite
to it. State the effect in terms of increase, decrease, or no effect on the ratio involved, and give the
reason for your answer. In all cases, assume that the current assets exceed the current liabilities
both before and after the event or transaction. Use the following format for your answers:

Effect on Ratio Reason for Increase, Decrease, or No Effect


1.
Etc.

PROBLEM 16-14 Effects of Transactions on Various Ratios LO16–2


Denna Company’s working capital accounts at the beginning of the year follow:

Cash ������������������������������������������������������������������� $50,000


Marketable securities ��������������������������������������� $30,000
Accounts receivable, net ��������������������������������� $200,000
Inventory ������������������������������������������������������������� $210,000
Prepaid expenses ��������������������������������������������� $10,000
Accounts payable ��������������������������������������������� $150,000
Notes due within one year ������������������������������ $30,000
Accrued liabilities ��������������������������������������������� $20,000

During the year, Denna Company completed the following transactions:


Ex. Paid a cash dividend previously declared, $12,000.
a. Issued additional shares of common stock for cash, $100,000.
b. Sold inventory costing $50,000 for $80,000, on account.
764 Chapter 16

c. Wrote off uncollectible accounts in the amount of $10,000, reducing the accounts receivable
balance accordingly.
d. Declared a cash dividend, $15,000.
e. Paid accounts payable, $50,000.
f. Borrowed cash on a short-term note with the bank, $35,000.
g. Sold inventory costing $15,000 for $10,000 cash.
h. Purchased inventory on account, $60,000.
i. Paid off all short-term notes due, $30,000.
j. Purchased equipment for cash, $15,000.
k. Sold marketable securities costing $18,000 for cash, $15,000.
l. Collected cash on accounts receivable, $80,000.
Required:
1. Compute the following amounts and ratios as of the beginning of the year:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
2. Indicate the effect of each of the transactions given above on working capital, the current
ratio, and the acid-test ratio. Give the effect in terms of increase, decrease, or none. Item Ex is
given below as an example of the format to use:

The Effect on
Working Current Acid-Test
Transaction Capital Ratio Ratio
Ex. Paid a cash dividend previously declared ��������� None Increase Increase

PROBLEM 16-15 Comprehensive Ratio Analysis LO16–2, LO16–3, LO16–4, LO16–5, LO16–6
You have just been hired as a financial analyst for Lydex Company, a manufacturer of safety hel-
mets. Your boss has asked you to perform a comprehensive analysis of the company’s financial
statements, including comparing Lydex’s performance to its major competitors. The company’s
financial statements for the last two years are as follows:

Lydex Company
Comparative Balance Sheet
This Year Last Year
Assets
Current assets:
Cash $ 960,000 $ 1,260,000
Marketable securities �����������������������������  0  300,000
Accounts receivable, net �����������������������  2,700,000  1,800,000
Inventory ���������������������������������������������������  3,900,000  2,400,000
Prepaid expenses �����������������������������������  240,000  180,000
Total current assets �������������������������������������  7,800,000  5,940,000
Plant and equipment, net ���������������������������  9,300,000  8,940,000
Total assets ��������������������������������������������������� $17,100,000 $14,880,000

Liabilities and Stockholders’ Equity


Liabilities:
Current liabilities ������������������������������������� $ 3,900,000 $ 2,760,000
Note payable, 10% ���������������������������������  3,600,000  3,000,000
Total liabilities �����������������������������������������������  7,500,000  5,760,000
Stockholders’ equity: ���������������������������������
Common stock, $78 par value �������������  7,800,000  7,800,000
Retained earnings �����������������������������������  1,800,000  1,320,000
Total stockholders’ equity �������������������������  9,600,000  9,120,000
Total liabilities and stockholders’ equity � $17,100,000 $14,880,000
Financial Statement Analysis 765

Lydex Company
Comparative Income Statement and Reconciliation
This Year Last Year
Sales (all on account) ��������������������������������� $15,750,000 $12,480,000
Cost of goods sold �������������������������������������  12,600,000  9,900,000
Gross margin �����������������������������������������������  3,150,000  2,580,000
Selling and administrative expenses �������  1,590,000  1,560,000
Net operating income ���������������������������������  1,560,000  1,020,000
Interest expense �����������������������������������������  360,000  300,000
Net income before taxes ���������������������������  1,200,000  720,000
Income taxes (30%) �������������������������������������  360,000  216,000
Net income ���������������������������������������������������  840,000  504,000
Common dividends �������������������������������������  360,000  252,000
Net income retained �����������������������������������  480,000  252,000
Beginning retained earnings ���������������������  1,320,000  1,068,000
Ending retained earnings ��������������������������� $ 1,800,000 $ 1,320,000

To begin your assignment you gather the following financial data and ratios that are typical of
companies in Lydex Company’s industry:

Current ratio ���������������������������������������������� 2.3


Acid-test ratio �������������������������������������������� 1.2
Average collection period ���������������������� 30 days
Average sale period �������������������������������� 60 days
Return on assets �������������������������������������� 9.5%
Debt-to-equity ratio ���������������������������������� 0.65
Times interest earned ratio �������������������� 5.7
Price-earnings ratio ���������������������������������� 10

Required:
1. You decide first to assess the company’s performance in terms of debt management and
p­ rofitability. Compute the following for both this year and last year:
a. The times interest earned ratio.
b. The debt-to-equity ratio.
c. The gross margin percentage.
d. The return on total assets. (Total assets at the beginning of last year were $12,960,000.)
e. The return on equity. (Stockholders’ equity at the beginning of last year totaled
$9,048,000. There has been no change in common stock over the last two years.)
f. Is the company’s financial leverage positive or negative? Explain.
2. You decide next to assess the company’s stock market performance. Assume that Lydex’s
stock price at the end of this year is $72 per share and that at the end of last year it was $40.
For both this year and last year, compute:
a. The earnings per share.
b. The dividend yield ratio.
c. The dividend payout ratio.
d. The price-earnings ratio. How do investors regard Lydex Company as compared to other
companies in the industry? Explain.
e. The book value per share of common stock. Does the difference between market value
per share and book value per share suggest that the stock at its current price is a bargain?
Explain.
3. You decide, finally, to assess the company’s liquidity and asset management. For both this
year and last year, compute:
a. Working capital.
b. The current ratio.
766 Chapter 16

c. The acid-test ratio.


d. The average collection period. (The accounts receivable at the beginning of last year
totaled $1,560,000.)
e. The average sale period. (The inventory at the beginning of last year totaled $1,920,000.)
f. The operating cycle.
g. The total asset turnover. (The total assets at the beginning of last year totaled
$12,960,000.)
4. Prepare a brief memo that summarizes how Lydex is performing relative to its competitors.

PROBLEM 16-16 Common-Size Financial Statements LO16–1


Refer to the financial statement data for Lydex Company given in Problem 16-15.
Required:
For both this year and last year:
1. Present the balance sheet in common-size format.
2. Present the income statement in common-size format down through net income.
3. Comment on the results of your analysis.

PROBLEM 16-17 Interpretation of Financial Ratios LO16–2, LO16–3, LO16–6


Pecunious Products, Inc.’s financial results for the past three years are summarized below:

Year 3 Year 2 Year 1


Sales trend ���������������������������������������� 128.0 115.0 100.0
Current ratio �������������������������������������� 2.5 2.3 2.2
Acid-test ratio ������������������������������������ 0.8 0.9 1.1
Accounts receivable turnover �������� 9.4 10.6 12.5
Inventory turnover ���������������������������� 6.5 7.2 8.0
Dividend yield ���������������������������������� 7.1% 6.5% 5.8%
Dividend payout ratio ���������������������� 40% 50% 60%
Dividends paid per share* �������������� $1.50 $1.50 $1.50

*There have been no changes in common stock outstanding over the


three-year period.

Your boss has asked you to review these results and then answer the following questions:
a. Is it becoming easier for the company to pay its bills as they come due?
b. Are customers paying their accounts at least as fast now as they were in Year 1?
c. Is the total of the accounts receivable increasing, decreasing, or remaining constant?
d. Is the level of inventory increasing, decreasing, or remaining constant?
e. Is the market price of the company’s stock going up or down?
f. Is the earnings per share increasing or decreasing?
g. Is the price-earning ratio going up or down?
Required:
Provide answers to each of the questions raised by your boss.

PROBLEM 16-18 Common-Size Statements and Financial Ratios for a Loan Application LO16–1,
LO16–2, LO16–3, LO16–4
Paul Sabin organized Sabin Electronics 10 years ago to produce and sell several electronic devices
on which he had secured patents. Although the company has been fairly profitable, it is now expe-
riencing a severe cash shortage. For this reason, it is requesting a $500,000 long-term loan from
Gulfport State Bank, $100,000 of which will be used to bolster the Cash account and $400,000 of
which will be used to modernize equipment. The company’s financial statements for the two most
recent years follow:
Financial Statement Analysis 767

Sabin Electronics
Comparative Balance Sheet
This Year Last Year
Assets
Current assets:
Cash �������������������������������������������������������� $ 70,000 $ 150,000
Marketable securities ����������������������������  0  18,000
Accounts receivable, net ����������������������  480,000  300,000
Inventory ��������������������������������������������������  950,000  600,000
Prepaid expenses ����������������������������������  20,000  22,000
Total current assets ������������������������������������  1,520,000  1,090,000
Plant and equipment, net ��������������������������  1,480,000  1,370,000
Total assets �������������������������������������������������� $3,000,000 $2,460,000

Liabilities and Stockholders’ Equity


Liabilities:
Current liabilities ������������������������������������ $ 800,000 $ 430,000
Bonds payable, 12% ������������������������������  600,000  600,000
Total liabilities ����������������������������������������������  1,400,000  1,030,000
Stockholders’ equity: ��������������������������������
Common stock, $15 par ����������������������  750,000  750,000
Retained earnings ����������������������������������  850,000  680,000
Total stockholders’ equity ������������������������  1,600,000  1,430,000
Total liabilities and stockholders’ equity ���� $3,000,000 $2,460,000

Sabin Electronics
Comparative Income Statement and Reconciliation
This Year Last Year
Sales ����������������������������������������������������������� $5,000,000 $4,350,000
Cost of goods sold �����������������������������������  3,875,000  3,450,000
Gross margin ���������������������������������������������  1,125,000  900,000
Selling and administrative expenses �����  653,000  548,000
Net operating income �������������������������������  472,000  352,000
Interest expense ���������������������������������������  72,000  72,000
Net income before taxes �������������������������  400,000  280,000
Income taxes (30%) �����������������������������������  120,000  84,000
Net income �������������������������������������������������  280,000  196,000
Common dividends �����������������������������������  110,000  95,000
Net income retained ���������������������������������  170,000  101,000
Beginning retained earnings �������������������  680,000  579,000
Ending retained earnings ������������������������� $ 850,000 $ 680,000

During the past year, the company introduced several new product lines and raised the selling
prices on a number of old product lines in order to improve its profit margin. The company also
hired a new sales manager, who has expanded sales into several new territories. Sales terms are
2/10, n/30. All sales are on account.
768 Chapter 16

Required:
1. To assist in approaching the bank about the loan, Paul has asked you to compute the following
ratios for both this year and last year:
a. The amount of working capital.
b. The current ratio.
c. The acid-test ratio.
d. The average collection period. (The accounts receivable at the beginning of last year
totaled $250,000.)
e. The average sale period. (The inventory at the beginning of last year totaled $500,000.)
f. The operating cycle.
g. The total asset turnover. (The total assets at the beginning of last year were $2,420,000.)
h. The debt-to-equity ratio.
i. The times interest earned ratio.
j. The equity multiplier. (The total stockholders’ equity at the beginning of last year totaled
$1,420,000.)
2. For both this year and last year:
a. Present the balance sheet in common-size format.
b. Present the income statement in common-size format down through net income.
3. Paul Sabin has also gathered the following financial data and ratios that are typical of compa-
nies in the electronics industry:

Current ratio ����������������������������������������������������������� 2.5


Acid-test ratio ��������������������������������������������������������� 1.3
Average collection period ����������������������������������� 18 days
Average sale period ��������������������������������������������� 60 days
Debt-to-equity ratio ����������������������������������������������� 0.90
Times interest earned ratio ��������������������������������� 6.0

 omment on the results of your analysis in (1) and (2) above and compare Sabin Electronics’
C
performance to the benchmarks from the electronics industry. Do you think that the company
is likely to get its loan application approved?

PROBLEM 16-19 Financial Ratios for Assessing Profitability and Market Performance
LO16–5, LO16–6
Refer to the financial statements and other data in Problem 16-18. Assume Paul Sabin has asked
you to assess his company’s profitability and stock market performance.
Required:
1. You decide first to assess the company’s stock market performance. For both this year and last
year, compute:
a. The earnings per share. There has been no change in common stock over the last two
years.
b. The dividend yield ratio. The company’s stock is currently selling for $40 per share; last
year it sold for $36 per share.
c. The dividend payout ratio.
d. The price-earnings ratio. How do investors regard Sabin Electronics as compared to
other companies in the industry if the industry norm for the price-earnings ratio is 12?
Explain.
e. The book value per share of common stock. Does the difference between market value
and book value suggest that the stock is overpriced? Explain.
2. You decide next to assess the company’s profitability. Compute the following for both this
year and last year:
a. The gross margin percentage.
b. The net profit margin percentage.
c. The return on total assets. (Total assets at the beginning of last year were $2,420,000.)
Financial Statement Analysis 769

d. The return on equity. (Stockholders’ equity at the beginning of last year was $1,420,000.)
e. Is the company’s financial leverage positive or negative? Explain.
3. Comment on the company’s profit performance and stock market performance over the two-
year period.

PROBLEM 16-20 Ethics and the Manager LO16–2, LO16–4


Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had
designed for doing aerial tricks. Up to this point, Russ has financed the company with his own
savings and with cash generated by his business. However, Russ now faces a cash crisis. In the
year just ended, an acute shortage of high-impact roller bearings developed just as the company
was beginning production for the Christmas season. Russ had been assured by his suppliers that
the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were
unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfin-
ished skates at the end of the year and was unable to fill all of the orders that had come in from
retailers for the Christmas season. Consequently, sales were below expectations for the year, and
Russ does not have enough cash to pay his creditors.
Well before the accounts payable were due, Russ visited a local bank and inquired about
obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem
getting a loan to pay off his accounts payable—providing that on his most recent financial state-
ments the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income
was at least four times the interest on the proposed loan. Russ promised to return later with a copy
of his financial statements.
Russ would like to apply for a $80,000 six-month loan bearing an interest rate of 10% per year.
The unaudited financial reports of the company appear below:

Venice InLine, Inc.


Comparative Balance Sheet As of December 31
(dollars in thousands)
This Year Last Year
Assets
Current assets:
Cash ������������������������������������������������������������������ $ 70 $150
Accounts receivable, net ��������������������������������  50  40
Inventory ������������������������������������������������������������  160  100
Prepaid expenses ��������������������������������������������  10  12
Total current assets ����������������������������������������������  290  302
Property and equipment ������������������������������������  270  180
Total assets ������������������������������������������������������������ $560 $482

Liabilities and Stockholders’ Equity


Current liabilities:
Accounts payable �������������������������������������������� $154 $ 90
Accrued liabilities ��������������������������������������������  10  10
Total current liabilities ������������������������������������������  164  100
Long-term liabilities ����������������������������������������������  —  —
Total liabilities ��������������������������������������������������������  164  100
Stockholders’ equity:
 Common stock and additional paid-in
capital ������������������������������������������������������������  100  100
Retained earnings ��������������������������������������������  296  282
Total stockholders’ equity ����������������������������������  396  382
Total liabilities and stockholders’ equity ���������� $560 $482
770 Chapter 16

Venice InLine, Inc.


Income Statement
For the Year Ended December 31
(dollars in thousands)
This Year
Sales (all on account) �������������������������������������������������������������������������� $ 420
Cost of goods sold ������������������������������������������������������������������������������  290
Gross margin ����������������������������������������������������������������������������������������  130
Selling and administrative expenses:
Selling expenses ������������������������������������������������������������������������������  42
Administrative expenses ����������������������������������������������������������������  68
Total selling and administrative expenses ��������������������������������������  110
Net operating income ��������������������������������������������������������������������������  20
Interest expense ����������������������������������������������������������������������������������  —
Net income before taxes ��������������������������������������������������������������������  20
Income taxes (30%) ������������������������������������������������������������������������������  6
Net income �������������������������������������������������������������������������������������������� $ 14

Required:
1. Based on the unaudited financial statements and the statement made by the loan officer, would
the company qualify for the loan?
2. Last year Russ purchased and installed new, more efficient equipment to replace an older plas-
tic injection molding machine. Russ had originally planned to sell the old machine but found
that it is still needed whenever the plastic injection molding process is a bottleneck. When
Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the
old machine be sold or at least reclassified as inventory on the balance sheet because it could
be readily sold. At present, the machine is carried in the Property and Equipment account and
could be sold for its net book value of $45,000. The bank does not require audited financial
statements. What advice would you give to Russ concerning the machine?

PROBLEM 16-21 Incomplete Statements; Ratios Analysis LO16–2, LO16–3, LO16–4, LO16–5, LO16–6
Incomplete financial statements for Pepper Industries follow:

Pepper Industries
Balance Sheet
March 31
Current assets:
Cash ��������������������������������������������������������������� $    ?
Accounts receivable, net ����������������������������� ?
Inventory ���������������������������������������������������������   ?
Total current assets ������������������������������������������� ?
Plant and equipment, net ���������������������������������   ?
Total assets ��������������������������������������������������������� $   ?
Liabilities:
Current liabilities ������������������������������������������� $ 320,000
Bonds payable, 10% �������������������������������������   ?
Total liabilities �����������������������������������������������������   ?
Stockholders’ equity:
Common stock, $5 par value ��������������������� ?
Retained earnings �����������������������������������������   ?
Total stockholders’ equity �������������������������������   ?
Total liabilities and stockholders’ equity ������� $   ?
Financial Statement Analysis 771

Pepper Industries
Income Statement
For the Year Ended March 31
Sales ���������������������������������������������������������������� $4,200,000
Cost of goods sold ����������������������������������������               ?
Gross margin �������������������������������������������������� ?
Selling and administrative expenses ����������               ?
Net operating income ������������������������������������ ?
Interest expense ��������������������������������������������  80,000
Net income before taxes ������������������������������ ?
Income taxes (30%) ����������������������������������������               ?
Net income ������������������������������������������������������ $  ?

The following additional information is available about the company:


a. All sales during the year were on account.
b. There was no change in the number of shares of common stock outstanding during the year.
c. The interest expense on the income statement relates to the bonds payable; the amount of
bonds outstanding did not change during the year.
d. Selected balances at the beginning of the current year were:

Accounts receivable ������������������� $270,000


Inventory ��������������������������������������� $360,000
Total assets ����������������������������������� $1,800,000

e. Selected financial ratios computed from the statements above for the current year are:

Earnings per share ����������������������������� $2.30


Debt-to-equity ratio ����������������������������� 0.875
Accounts receivable turnover ����������� 14.0
Current ratio ����������������������������������������� 2.75
Return on total assets ������������������������� 18.0%
Times interest earned ratio ��������������� 6.75
Acid-test ratio ��������������������������������������� 1.25
Inventory turnover ������������������������������� 6.5

Required:
Compute the missing amounts on the company’s financial statements. (Hint: What’s the difference
between the acid-test ratio and the current ratio?)

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