CHAPTER 3 Working with Financial Statements

Formula:
Asset + , Liability - , Cash outflow=Use
Asset - , Liability +, Cash inflow/Save=Source
Common Size Statements
Balance Sheet- Percentage of Assets
Income Staement- Percentage of Sales
Common Base year Assets- Dividing year by base year
Combined common size and base year Assets- Dividing year (common base) by base year
Ratio Analysis-

Du Pont Identity, ROE = Profit margin X Total asset turnover X Equity multiplier

Short-term solvency/Liquidity ratios: Long-term solvency ratios:

Current ratio = Current assets / Current liabilities Total debt ratio = (Total assets – Total equity) / Total assets
Quick ratio = (Current assets – Inventory)/Current Debt-equity ratio = Total debt / Total equity
liabilities Equity multiplier = 1 + D/E
Cash ratio = Cash / Current liabilities Times interest earned = EBIT / Interest
Cash coverage ratio = (EBIT + Depreciation) / Interest
Asset utilization ratios: Profitability ratios:
Total asset turnover = Sales / Total assets Profit margin = Net income / Sales
Inventory turnover = Cost of goods sold / Inventory Return on assets = Net income / Total assets
Receivables turnover = Sales / Accounts receivable Return on equity = Net income / Total equity
Price-Earnings ratio = Shares price / Earnings per share Market-to-book ratio = Share price / Book value per share
Earnings per share = Net income / Shares Book value per share = Total equity / Shares
Dividends per share = Dividends / Shares PEG ratio = P/E ratio / Growth rate
Tobin’s Q=(Market value of equity+Book value of Market value of equity = Shares × Share price
debt)/Book value of assets Total debt = Current liabilities + Long-term debt
Page-77 (3.1)

Sol:
Page-77 (3.2)

Sol: Common-Size Income Statement (2009)

Sales = 100%

Item Amount ($ millions) % of Sales

Sales 4,053 100.00%
Cost of goods sold 2,780 68.6%
Depreciation 550 13.6%
Earnings before interest and taxes (EBIT) 723 17.8%
Interest paid 502 12.4%
Taxable income 221 5.5%
Taxes (34%) 75 1.9%
Net income 146 3.6%
Dividends 47 1.2%
Addition to retained earnings 99 2.4%

Interpretation
Page-78 (3.3)

Sol: Financial Ratios (2009)

Liquidity Ratios
Ratio Formula Calculation Value
Current assets / Current
Current ratio 853 / 1,725 0.49 times
liabilities
Quick ratio (CA − Inventory) / CL (853 − 328) / 1,725 0.30 times
Cash ratio Cash / CL 215 / 1,725 0.12 times
Asset Management Ratios
Ratio Formula Calculation Value
Inventory turnover COGS / Inventory 2,780 / 328 8.48 times
Receivables turnover Sales / A/R 4,053 / 310 13.07 times
Days’ sales in inventory 365 / Inv. turnover 365 / 8.48 43.06 days
Days’ sales in receivables 365 / Rec. turnover 365 / 13.07 27.92 days
Debt Management Ratios
Ratio Formula Calculation Value
Total debt ratio Total liabilities / Total assets 4,033 / 7,380 0.55 or 55.00%
Long-term debt ratio LT debt / (LT debt + Equity) 2,308 / (2,308 + 3,347) 0.41 or 41.00%
Coverage Ratios
Ratio Formula Calculation Value
Times interest earned EBIT / Interest 723 / 502 1.44 times
Cash coverage ratio (EBIT + Depreciation) / Interest (723 + 550) / 502 2.54 times
Summary Interpretation
Area Interpretation
Liquidity Weak (all liquidity ratios well below 1.0)
Efficiency Strong inventory and receivables management
Leverage Moderately high debt usage
Coverage Interest is covered, but with limited margin

Page-78 (3.4)

Sol:
Page-81 (6)

Sol:
Net income = Addition to Retained Earnings + Dividends = $430,000 + 175,000 = $605,000
Earnings per share = Net Income / Shares = $605,000 / 210,000 = $2.88 per share
Dividends per share = Dividends / Shares = $175,000 / 210,000 = $0.83 per share
Book value per share = Total Equity/ Shares = $5,300,000 / 210,000 = $25.24 per share
Market-to-book ratio = Share price / Book value per share = $63 / $25.24 = 2.50 times
P/E ratio = Share price / EPS = $63 / $2.88 = 21.87 times
Sales per share = Sales / Shares = $4,500,000 / 210,000 = $21.43
P/S ratio = Share price / Sales per share = $63 / $21.43 = 2.94 times

Page-81 (7)

Sol: ROE = (PM)(TAT)(EM)= (.055)(1.15)(2.80) = 0.1771 or 17.71%

Page-83 (18)

Sol:
This is a multi-step problem involving several ratios. The ratios given are all part of the DuPont Identity. The
only DuPont Identity ratio not given is the profit margin. If we know the profit margin, we can find the net
income since sales are given. So, we begin with the DuPont Identity:
ROE = 0.15 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E)
Solving the DuPont Identity for profit margin, we get:
PM = [(ROE)(TA)] / [(1 + D/E)(S)]= [(0.15)($3,105)] / [(1 + 1.4)( $5,726)] = .0339
Now that we have the profit margin, we can use this number and the given sales figure to solve for net income:
PM = .0339 = NI / S
NI = .0339($5,726) = $194.06
Page-82 (13-17)
Sol: 13-15

The common-size balance sheet answers are found by dividing each category by total assets. For example, the
cash percentage for 2008 is: $8,436 / $295,432 = .0286 or 2.86%, This means that cash is 2.86% of total assets.

The common-base year answers for Question 14 are found by dividing each category value for 2009 by the same
category value for 2008. For example, the cash common-base year number is found by: $10,157 / $8,436 = 1.2040
This means the cash balance in 2009 is 1.2040 times as large as the cash balance in 2008.

The common-size, common-base year answers for Question 15 are found by dividing the commonsize
percentage for 2009 by the common-size percentage for 2008. For example, the cash calculation is found by:
3.13% / 2.86% = 1.0961, This tells us that cash, as a percentage of assets, increased by 9.61%.

16. The firm used $29,087 in cash to acquire new assets. It raised this amount of cash by increasing liabilities and
owners’ equity by $29,087. In particular, the needed funds were raised by internal financing (on a net basis), out of the
additions to retained earnings, an increase in current liabilities, and by an issue of long-term debt.
17.
a. Current ratio = Current assets / Current d. NWC ratio = NWC / Total assets f. Total debt ratio = (Total assets
liabilities For 2008 = ($68,726 – 61,434) / – Total equity) / Total assets
For 2008 = $68,726 / $61,434 = 1.12 times $295,432 = 2.47% For 2008 = ($295,432 – 208,998) /
For 2009 = $76,213 / $64,203 = 1.19 times For 2009 = ($76,213 – 64,203) / $295,432 = 0.29
b. Quick ratio = (Current assets – Inventory) $324,519 = 3.70% For 2009 = ($324,519 – 228,316) /
/ Current liabilities e. Debt-equity ratio = Total debt / $324,519 = 0.30
For 2008 = ($67,726 – 38,760) / $61,434 = 0.49 Total equity Long-term debt ratio = Long-
times For 2008 = ($61,434 + 25,000) / term debt / (Long-term debt +
For 2009 = ($76,213 – 42,650) / $64,203 = 0.52 $208,998 = 0.41 times Total equity)
times For 2009 = ($64,206 + 32,000) / For 2008 = $25,000 / ($25,000 +
c. Cash ratio = Cash / Current liabilities $228,316 = 0.42 times 208,998) = 0.11
For 2008 = $8,436 / $61,434 = 0.14 times Equity multiplier = 1 + D/E For 2009 = $32,000 / ($32,000 +
For 2009 = $10,157 / $64,203 = 0.16 times For 2008 = 1 + 0.41 = 1.41 228,316) = 0.12
For 2009 = 1 + 0.42 = 1.42
Page-84 (26-30)
Solution:
26.
Short-term solvency ratios: Long-term solvency ratios:
Current ratio = Current assets / Current liabilities Total debt ratio = (Total assets – Total equity) / Total assets
Current ratio 2008 = $56,260 / $38,963 = 1.44 times Total debt ratio 2008 = ($290,328 – 176,365) / $290,328 = 0.39
Current ratio 2009 = $60,550 / $43,235 = 1.40 times Total debt ratio 2009 = ($321,075 – 192,840) / $321,075 = 0.40

Quick ratio = (Current assets – Inventory) / Current Debt-equity ratio = Total debt / Total equity
liabilities Debt-equity ratio 2008 = ($38,963 + 75,000) / $176,365 = 0.65
Quick ratio 2008 = ($56,260 – 23,084) / $38,963 = 0.85 times Debt-equity ratio 2009 = ($43,235 + 85,000) / $192,840 = 0.66
Quick ratio 2009 = ($60,550 – 24,650) / $43,235 = 0.83 times
Equity multiplier = 1 + D/E
Cash ratio = Cash / Current liabilities Equity multiplier 2008 = 1 + 0.65 = 1.65
Cash ratio 2008 = $21,860 / $38,963 = 0.56 times Equity multiplier 2009 = 1 + 0.66 = 1.66
Cash ratio 2009 = $22,050 / $43,235 = 0.51 times
Times interest earned = EBIT / Interest= 68,045 / 11,930 = 5.70 times
Cash coverage ratio = (EBIT + Depreciation) / Interest=
($68,045 + 26,850) / $11,930 = 7.95 times
Asset utilization ratios: Profitability ratios:
Total asset turnover = Sales / Total assets= $305,830 / Profit margin = Net income / Sales= $36,475 / $305,830 =
$321,075 = 0.95 times 0.1193 or 11.93%
Inventory turnover = Cost of goods sold / Inventory= Return on assets = Net income / Total assets = $36,475 /
$210,935 / $24,650 = 8.56 times $321,075 = 0.1136 or 11.36%
Receivables turnover = Sales / Accounts receivable= Return on equity = Net income / Total equity = $36,475 /
$305,830 / $13,850 = 22.08 times $192,840 = 0.1891 or 18.91%

27. The DuPont identity is:

ROE = (PM)(TAT)(EM)= (0.1193)(0.95)(1.66) = 0.1891 or 18.91%

28. 2009 Statement of Cash Flows

Cash flows from Operating Activities
Net income $ 36,475
Depreciation $ 26,850
Changes in Working Capital
(Increase)/Decrease in Accounts Receivable (2,534)
(Increase)/Decrease in Closing Inventory (1,566)
Increase/(Decrease) in Accounts Payable 3,530
Increase/(Decrease) in Notes Payable (1,000)
Increase/(Decrease) in Others Payable 1,742
Total Cash flows from Operating Activities (A) 63,497
Cash flows from Investing Activities
Cash Receipt For
Sale of Property and Equipment -
Encashment Investment -
Cash Paid For
Purchase of Property, Plant & Equipments (53,307)
Purchase of Investment Securities/FDR -
Total Cash flows from Investing Activities: (B) (53,307)
Cash flows from Financing Activities:
Cash Receipt From
Owner's Capital -
Loan term debt 10,000
Cash Paid For
Dividend Paid (20,000)
Total Cash flows from Financing Activities (C) (10,000)
Net increase in cash (A+B+C) $ 190
Add: Opening Cash & Cash Equivalents $ 21,860
Closing Cash & Cash Equivalents $ 22,050
29. Earnings per share = Net income / Shares= $36,475 / 25,000 = $1.46 per share
Price-Earnings ratio = Shares price / Earnings per share= $43 / $1.46 = 29.47 times
Dividends per share = Dividends / Shares= $20,000 / 25,000 = $0.80 per share

Book value per share = Total equity / Shares= $192,840 / 25,000 shares = $7.71 per share
Market-to-book ratio = Share price / Book value per share= $43 / $7.71 = 5.57 times

PEG ratio = P/E ratio / Growth rate= 29.47 / 9 = 3.27 times

30. First, we will find the market value of the company’s equity, which is:
Market value of equity = Shares × Share price = 25,000($43) = $1,075,000

The total book value of the company’s debt is:

Total debt = Current liabilities + Long-term debt= $43,235 + 85,000 = $128,235

Now we can calculate Tobin’s Q, which is:

Tobin’s Q=(Market value of equity+Book value of debt)/Book value of assets= ($1,075,000 + 128,235) / $321,075= 3.75

Using the book value of debt implicitly assumes that the book value of debt is equal to the market value of debt. This
assumption is generally true. Using the book value of assets assumes that the assets can be replaced at the current
value on the balance sheet. There are several reasons this assumption could be flawed. First, inflation during the life of
the assets can cause the book value of the assets to understate the market value of the assets. Since assets are recorded
at cost when purchased, inflation means that it is more expensive to replace the assets. Second, improvements in
technology could mean that the assets could be replaced with more productive, and possibly cheaper, assets. If this is
true, the book value can overstate the
market value of the assets. Finally, the book value of assets may not accurately represent the market value of the assets
because of depreciation. Depreciation is done according to some schedule, generally straight-line or MACRS. Thus,
the book value and market value can often diverge.
Page-85-86, Minicase
Solution:
Question 1: Ratio Calculations
Liquidity Ratios
1. Current Ratio= Current assets / Current liabilities= 2,186,520/2,919,000=0.75 times
2. Quick Ratio= (Current assets – Inventory) / Current liabilities = (2,186,520−1,037,120)/2,919,000=0.39
3. Cash Ratio = Cash / Current liabilities = 441,000/2,919,000=0.15 times
Asset Management Ratios
4. Total Asset Turnover= Sales / Total assets= 30,499,420/18,308,920=1.67
5. Inventory Turnover= Cost of goods sold / Inventory= 22,224,580/1,037,120=21.43
6. Receivables Turnover= Sales / Accounts receivable= 30,499,420/708,400=43.05
Debt Management Ratios
7. Total Debt Ratio= (Total assets – Total equity) / Total assets= (18,308,920-10,069,920)/ 18,308,920=0.45
8. Debt-to-Equity Ratio= Total debt / Total equity= 8,239,000/10,069,920=0.82
9. Equity Multiplier= 1 + D/E = 1+ 8,239,000/10,069,920=1.82
[Link] Interest Earned (TIE)= EBIT / Interest= 3,040,660/478,240=6.36
[Link] Coverage Ratio= (EBIT + Depreciation) / Interest= (3,040,660+1,366,800)/478,240=9.22
Profitability Ratios
[Link] Margin= Net income / Sales=1,537,452/30,499,420=5.04%
[Link] on Assets (ROA)= Net income / Total assets = 1,537,452/18,308,920=8.40%
[Link] on Equity (ROE)= Net income / Total equity =1,537,452/10,069,920=15.27%

Question 2:
Aspirant Company Choice
Should S&S Air choose Boeing as an aspirant company?
No.
Boeing is one of the world's largest, most diversified, and most complex aerospace companies, focused primarily on
large commercial jetliners, defense, and space.
Reasons against Boeing:
• Product: S&S Air produces small, light airplanes for a niche consumer market. Boeing builds massive, multi-
million dollar commercial jetliners for major airlines (a completely different business model, scale, and
customer base).
• Operations/Scale: S&S Air's competitive advantage is its short, 5-week build time using prefabricated parts.
Boeing's operations involve multi-year design, regulatory approval, and manufacturing processes for massive
aircraft. The scales of assets, sales, and debt are incomparable.
• Ratios: Comparing S&S Air's small-scale, niche ratios to Boeing's massive, diversified ratios would provide
misleading benchmarks for performance evaluation and goal setting.
Better Aspirant Companies:
A better set of aspirant companies would be those that operate in the General Aviation/Small Aircraft sector, which
includes those listed in the question:
• Cessna Aircraft Company: A classic and primary competitor in the small piston and turboprop aircraft
market.
• Cirrus Design Corporation: A direct competitor known for its high-performance single-engine planes.
• Bombardier and Embraer: While larger than S&S Air, they focus on regional jets and business aircraft, which
is closer to S&S Air's scale and market than Boeing.
Using these firms would provide relevant, comparable, and actionable benchmarks for Chris Guthrie's ratio analysis.
Question 3: Comparison to Industry
S&S Industry
Ratio Comments
Air Median
Much weaker liquidity. S&S Air has significantly less current assets per dollar
Current ratio 0.75 1.43 of current liabilities than the industry. This signals a poor liquidity position
and a higher risk of being unable to pay short-term debts.
About average. Although close, S&S Air is slightly better than the industry
Quick ratio 0.39 0.38 when excluding inventory. This suggests that the major liquidity issue is the low
amount of current assets overall, and not just in accounts receivable and cash.
Cash ratio 0.15 0.21 Below average
Excellent efficiency. S&S Air generates $1.67 in sales for every dollar in assets,
Total asset turnover 1.67 0.85 nearly double the industry median. This indicates highly efficient utilization of
its total assets to generate sales.
Far superior. S&S Air turns over its inventory much faster than the industry.
This is a strong positive and is expected, as the case states they build aircraft "to
Inventory turnover 21.43 6.15
order" using prefabricated parts in only five weeks, minimizing stored
inventory.
Receivables turnover 43.05 9.82 Very strong collections
S&S Air uses less debt (45% of assets are financed by debt) than the industry
Total Debt Ratio 0.45 0.52
(52%). This is a lower financial risk position.
Less leverage. Consistent with the Total Debt Ratio, S&S Air uses less debt
Debt-to-equity 0.82 1.08
relative to equity. It is less leveraged than its peers.
Slightly weaker. S&S Air's EBIT covers its interest expense fewer times than the
TIE 6.36 8.06 industry. This suggests a lower ability to service its debt payments from
operating profits, despite having lower debt overall.
When factoring in non-cash depreciation, S&S Air's operating cash flow covers
Cash Coverage Ratio 9.16 8.43 its interest expense better than the industry. This is a strong positive and a more
realistic measure of debt-servicing ability than TIE.
Below average. S&S Air keeps less profit (5.04 cents) for every dollar of sales
Profit margin 5.04% 6.98% compared to the industry (6.98 cents). This suggests poor cost control or lower
pricing power.
Below average. The company earns less net income per dollar of assets than its
ROA 8.40% 10.53%
peers.
Slightly below. S&S Air provides a lower return to its shareholders than the
ROE 15.27% 16.54%
industry average. This is the ultimate measure of performance.

Analysis Summary and Conclusion

Overall Performance: S&S Air's performance is mixed, but the key issues are liquidity and profit margin.
• Strengths: The company is exceptionally good at asset utilization (high Total Asset Turnover and Inventory
Turnover), indicating a very efficient production and sales process (likely due to its build-to-order model). It is
also less leveraged than the industry and has a superior Cash Coverage Ratio.
• Weaknesses: The company is dangerously illiquid (Current Ratio of 0.75 vs. industry 1.43). Its Profit Margin
is low, pulling down its overall profitability (ROA and ROE).
The DuPont Identity (ROE = Profit Margin × Total Asset Turnover × Equity Multiplier) helps explain the low ROE:
S&S Air ROE: 5.04%×1.67×1.82=15.35% (vs. Industry 16.54%)
S&S Air's excellent asset turnover (1.67) is being canceled out by its poor profit margin (5.04%), resulting in a slightly
below-average ROE.

Inventory Ratio Interpretation

1. S&S Air's Ratio:
Inventory/Current Liabilities=$1,037,120/$2,919,000=∗∗0.355∗∗
2. Comparison:
 • S&S Air's ratio of 0.355 means its inventory covers about 35.5% of its short-term debt.
• The industry's current liabilities are higher relative to inventory (as shown by their much lower
Inventory Turnover of 6.15 vs. S&S Air's 21.43).
• A high Inventory Turnover suggests S&S Air is quickly turning inventory into sales. Therefore,
relative to its small inventory holding, its current liabilities are very high.
Conclusion: S&S Air's ratio (0.355) would likely be lower than the industry average. The industry holds inventory for
much longer (lower turnover), so their inventory value relative to their current liabilities (the denominator) is likely
higher than S&S Air's. S&S Air's illiquidity (low Current Ratio) means the denominator (Current Liabilities) is large
relative to its small Inventory (numerator).