7ce_Ch13_How_Well_Am_I_Doing_Financial_Statement_Analysis (1)
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LEARNING OBJECTIVES AND CHAPTER COMPETENCIES
After studying Chapter 13, you should be able to demonstrate the following competencies:
COMPETENCY
Know
Apply
LO1
PREPARE FINANCIAL STATEMENTS IN DIFFERENT FORMATS.
CC1
Prepare and interpret financial statements in comparative and common-size forms.
LO2
COMPUTE VARIOUS FINANCIAL RATIOS TO ASSESS FINANCIAL PERFORMANCE.
CC2
Compute and interpret financial ratios used to measure common shareholders’ well-being.
CC3
Compute and interpret financial ratios used to measure short-term creditors’ well-being.
CC4
Compute and interpret financial ratios used to measure long-term creditors’ well-being.
“How Well Am I Doing?”—
Financial Statement Analysis
13
Paulo Vilela/Shutterstock
“How Well Am I Doing?”—Financial Statement Analysis 633
Note to student: See Guidance
Answers
online.
Critical thinking question What role do you see for financial analysis using a tool like financial ratios for a company besieged by a crisis of its own making compromising its integrity?
?
ON THE JOB
REPORTING FOR INTERNAL USE AND DECISION MAKING AT VENDASTA
A
Vendasta is a Canadian technology company that provides an end-to-end platform used exclusively by local experts (channel partners) who sell digital products and services to small and medium businesses. These channel partners use the software platform and its associated products to help over 5.5 million business clients leverage digital avenues of attracting and keeping customers/clients. Tools range from social media marketing, to online directory listing syncing, to email and document cloud solutions. Vendasta also provides marketing services to customers who need help fulfilling these services for their growing client base.
Vendasta’s professional channel partners pay a monthly subscription and purchase products to enhance the services they provide to their clients. These purchases provide Ven-
dasta with monthly recurring revenue
. Vendasta pays soft-
ware expenses and cloud costs to host the platform and digital solutions for its partners. The direct costs allow for a stable margin on sales. Besides hosting and product costs, Vendasta’s largest expenses are wages, salaries, and bene-
fits to support company operations as well as the research, development, marketing, and sales of the Vendasta plat-
form. For a growing software as a service (SaaS) company, these expenses are high and often delay profitability.
The company uses common industry ratios, known as “SaaS metrics,” to better understand the overall health and viability of its business. These metrics allow the company to address cost issues and guide decision making in relation to pricing and sales strategies. Vendasta relies heavily on the LTV:CAC ratio, which is:
Lifetime value of a customer (LTV) : Cost of acquiring a customer (CAC)*
*LTV =
Average monthly revenue ×
Average months of lifetime
CAC =
Total sales and marketing expenses ÷
Number of new customers acquired.
If the costs to acquire a customer fall short of the total cost of the consumer-facing price points of the software and its associated products, it’s an indicator of risk to the viability of the company. In order to improve the LTV:CAC ratio, Vendasta added a lower tiered self-sign-up subscription with a de-
creased sales spend. In turn, this decreased the cost to acquire these customers. When these partners find success within the platform, the cost to convert them to a higher sub-
scription is lower than the cost to sign them up on a higher subscription from the beginning. This new level of subscrip-
tion allowed Vendasta to allocate sales and marketing efforts to partners with a higher monthly recurring revenue.
Shutterstock/NakoPhotography
A Look Back
A Look at This Chapter
A Look Ahead
Chapter 12 introduced the concepts of decentralization and performance measurement to evaluate different types of responsibility centres.
In Chapter 13, we focus on the analysis of financial statements to help forecast the financial health of a company. We discuss the use of trend data, comparisons with other organizations, and the analysis of fundamental financial ratios.
We cover the cash flow statement in Chapter 14, which is available on Connect. We address how to classify various types of cash inflows and outflows, and how to interpret information reported on the cash flow statement.
634
Chapter 13
I
ncreasingly, firms have to look to the financial markets for much-needed financial capital. Companies must present their past performance and future expectations in accordance with established guidelines for financial reporting and clearly express their financial prospects to the financial marketplace. This is accomplished using financial statements.
All financial statements are essentially historical documents. They explain what happened
during a particular period. However, most users of financial statements are concerned about what will happen
in the future. Shareholders are concerned with future earnings and dividends. Creditors are concerned with the company’s future ability to repay its debts. Managers are concerned with the company’s abil-
ity to finance future expansion. Despite the fact that financial statements reflect the past, they can still provide valuable information on all of these forward-looking concerns.
Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios. In this chapter, we consider some of the more important ratios and other analytical tools that financial analysts use.
Managers are also very concerned with the financial ratios discussed in this chapter, as the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would ordinarily be used in a balanced scorecard, as discussed in Chapter 12, although the specific ratios selected depend on the company’s strategy. For example, a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio discussed later in this chapter. Similarly, the gross margin ratio provides a strong signal regarding the outcomes of efforts to reduce the cost of goods sold. In addition, since they must report to shareholders and may wish to raise funds from external sources, managers must pay attention to the financial ratios used by external investors to evaluate the company’s investment potential and creditworthiness.
Limitations of Financial Statement Analysis in Business Today
Although financial statement analysis is a highly useful tool, it has two limitations that we must mention before proceeding any further. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.
Comparison of Financial Data
Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies’ financial data. For example, if one firm depreciates its assets using the double-declining balance method and another firm by the straight-line method, then direct com-
parisons of financial data between the two firms may be misleading. Sometimes, enough data are presented in footnotes to the financial statements to restate data on a comparable basis, but the analyst should evaluate the data’s comparability before drawing any definite conclusions. With this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.
The Need to Look Beyond Ratios
An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future, but this may not be appropriate. Conclusions based on ratio analysis must be regarded as tentative. Ratios should not be viewed as an end but, rather, as a starting point,
as indicators of what to pursue in greater depth. They raise many questions, but they rarely completely answer any questions by themselves.
In addition to ratios, other sources of data should be analyzed in order to make judgments about the future of an organization. The analyst should look at industry trends and at changes in technology, in consumer tastes, in the economy at large, and within the company itself. For example, recent turnover in a key management position might provide a basis for optimism about the future, even though the past performance of the company (as shown by its ratios) may have been mediocre.
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“How Well Am I Doing?”—Financial Statement Analysis 635
FINANCIAL PERFORMANCE AT TIM HORTONS USING NON-GAAP METRICS
B
For businesses to succeed financially, they need to increase revenue and manage costs. For a company in a highly volatile industry where cash burn rates are high, good cash management and liquidity are extremely important. Fast-food restaurants must particularly focus on quick turnover (especially because much of the food and many of the ingredients are perishable) and must watch costs very carefully. Managers must therefore pay close attention to key ratios such as cost to sales (or gross margin), inventory turnover, and (of course) sales growth. Although ratios related to long-term borrowing and equity will be important, any company will likely not succeed over the long term if it cannot manage its operations well to generate revenues and build a healthy cashflow. What about investors? It is interesting to see what companies think might matter to their investors.
Consider Tim Hortons. In addition to traditional financial metrics, Tim Hortons reports certain “non-GAAP” financial metrics—that is, metrics that do not have standardized meanings under generally accepted accounting principles (GAAP) and as such may differ from similarly labelled measures of other companies. Nonetheless, in the words of the company, “We believe that . . . non-GAAP measures are useful to investors in assessing our operating performance, . . . [providing] them with the same tools that management uses to evaluate our performance and . . . [being] responsive to questions we receive from both investors and analysts.”
One non-GAAP measure is earnings before interest, taxes, depreciation, and amortiz-
ation (EBITDA), which is used to assess the operating performance of the business. Financial analysts typically study both the traditional financial measures of performance and the non-GAAP measures that are reported by companies, keeping in mind that the self-reported measures that are not subject to any reporting standards will have to be viewed cautiously.
IN BUSINESS
CREDIT ANALYST
You work for a company that sells industrial products to businesses. Your company routinely sells products to customers on credit—expecting to be repaid within a specified period. A potential customer has asked for an extension of the payment terms on a very large sale to a date later than your company usually allows. You have been asked to determine the creditworthiness of this customer and have been provided with a copy of the customer’s financial statements and accompanying footnotes that were included in the customer’s most recent annual report. What other information should you obtain before you begin your analysis?
Note to student: See Guidance
Answers
online.
DECISION POINT
Statements in Comparative and Common-Size Forms
Few figures appearing on financial statements have much significance standing by themselves. It is the relationship of one figure to another—and the amount and direction of change over time—that is import-
ant in financial statement analysis. How does the analyst focus on significant relationships? How does the analyst extract the important trends and changes in a company? Three analytical techniques are widely used: (1) dollar and percentage changes on statements, (2) common-size statements, and (3) ratios. The first and second techniques are discussed in this section; the third technique is discussed in the remainder of the chapter. To illustrate these analytical techniques, we analyze the financial statements of Brickey Electronics, a producer of computer components.
LO1
Know Apply
CC1: Prepare and interpret financial statements in comparative and common-size forms.
636
Chapter 13
Dollar and Percentage Changes on Statements
The starting point for financial statement analysis is to put statements in comparative form. This consists of putting two or more years’ data side by side. Statements cast in comparative form can reveal movements and trends and may give the analyst valuable clues as to what aspects of the financial results to probe.
Examples of financial statements placed in comparative form are given in Exhibit 13–1 and Exhibit 13–2. These statements of Brickey Electronics reveal that the company has been experiencing substantial growth. The data in these financial statements are used as a basis for discussion throughout the remainder of the chapter.
EXHIBIT 13–1 Comparative Balance Sheet
BRICKEY ELECTRONICS Comparative Balance Sheet December 31, Year 1 and Year 2 (dollars in thousands)
Increase (Decrease)
Year 2
Year 1
Amount
Percentage
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–%
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 Shareholders’ Equity
Current liabilities:
Accounts payable
$ 5,800
$ 4,000
$ 1,800
45.0%
Accrued payables
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%
Shareholders’ equity:
Preferred shares ($100 par;
20,000 shares issued)
2,000
2,000
–0–
–0–%
Common shares
(unlimited authorized, $12 par; 500,000 shares issued)
6,000
6,000
–0–
–0–%
Additional paid-in capital
1,000
1,000
–0–
–0–%
Total paid-in capital
9,000
9,000
–0–
–0–%
Retained earnings
8,000
6,970
1,030
14.8%
Total shareholders’ equity
17,000
15,970
1,030
6.4%
Total liabilities and shareholders’ equity
$31,500
$28,970
$ 2,530
8.7%
*Since we are measuring the amount of change between year 1 and year 2, the dollar amounts for year 1 become the base figures for expressing these changes in percentage form. For example, cash decreased by $1,150 between year 1 and year 2. This decrease expressed in percentage form is computed as follows: $1,150 ÷
$2,350 =
48.9%. Other percentage figures in this exhibit and Exhibit 13–2 are computed in the same way.
“How Well Am I Doing?”—Financial Statement Analysis 637
EXHIBIT 13–2 Comparative Income Statement and Reconciliation of Retained Earnings
BRICKEY ELECTRONICS Comparative Income Statement and Reconciliation of Retained Earnings For the Years Ended December 31, Year 1 and Year 2 (dollars in thousands)
Increase (Decrease)
Year 2
Year 1
Amount
Percentage
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)%
Operating expenses:
Selling expenses
7,000
6,500
500
7.7%
Administrative expenses
5,860
6,100
(240)
(3.9)%
Total operating 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)%
Less: Income taxes (30%)
750
960
(210)
(21.9)%
Net income
1,750
2,240
$ (490)
(21.9)%
Dividends to preferred shareholders, $6 per share
(see Exhibit 13–1)
120
120
Net income remaining for common shareholders
1,630
2,120
Dividends to common shareholders, $1.20 per share
600
600
Net income added to retained earnings
1,030
1,520
Retained earnings, beginning of year
6,970
5,450
Retained earnings, end of year
$ 8,000
$ 6,970
HORIZONTAL ANALYSIS Comparison of two or more years’ financial data is known as horizontal analysis
or trend analysis
. Horizontal analysis is facilitated by showing changes between years in both dollar and
percentage forms, as has been done in Exhibits 13–1 and 13–2.
Showing changes in dollar form helps the analyst focus on key factors that have affected profitability or financial position. For example, observe in Exhibit 13–2 that sales for year 2 were up $4 million over year 1 but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold.
Showing changes between years in percentage form helps the analyst gain perspective
and gain a feel for the significance
of the changes taking place. A $1 million increase in sales is much more significant if the prior year’s sales were $2 million than if the prior year’s sales were $20 million. In the first situation, the increase would be 50%—undoubtedly a significant increase for any firm. In the second situation, the increase would be only 5%—perhaps just a reflection of normal growth.
TREND PERCENTAGES Horizontal analysis of financial statements can also be carried out by com-
puting trend percentages
. Trend percentages
state several years’ financial data in terms of a base year. The base year equals 100%, with all other years stated as some percentage of this base. To illustrate, consider McDonald’s Corporation, the largest global food service retailer, with more than 38,000 restaurants worldwide. McDonald’s enjoyed consistent growth in income during 2016–2021 (except in 2020), as is shown by the following data:
2021
2020
2019
2018
2017
2016
Sales
$23,223
$19,208
$21,364
$21,258
$22,820
$24,622
Net income
$ 7,545
$ 4,731
$ 6,025
$ 5,924
$ 5,193
$ 4,687
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638
Chapter 13
By simply looking at these data, you can see that sales have fluctuated. But how rapidly did sales change, and what impact did it have on net income? It is difficult to answer these questions by looking at the raw data alone. The increases in sales and the increases in net income can be put into better perspective by stating them in terms of trend percentages, with 2012 as the base year. These percentages (all rounded) are set forth below:
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
Sales
84%
70%
77%
77%
83%
89%
92%
100%
102%
100%
Net income
138%
87%
110%
108%
95%
86%
83%
87%
102%
100%
The trend analysis is particularly striking when the data are plotted as in Exhibit 13–3. McDonald’s sales have declined as a trend in the 10- year period (2012–21), except from 2018 to 2019 and then again after the pandemic in 2021, but the company’s net income has consistently increased (except in 2020). We would now look at the company’s financial statements and the related disclosures to know the cause. Special expenditures on projects, changing customer preferences, and extraordinary charges are often typical reasons.
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2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
Sales
Net income
EXHIBIT 13–3 McDonald’s Corporation Trend Analysis of Sales and Net Income
Common-Size Statements
Key changes and trends can also be highlighted by the use of common-size statements. A common-size statement
is one that shows items in percentage form, as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. The preparation of common-size statements is known as vertical analysis
.
Common-size statements are particularly useful when comparing data from different companies. For example, in one recent year, Wendy’s net income was about $10 million, whereas McDonald’s was $7,545 million. This comparison is somewhat misleading, because of the dramatically different sizes of the two companies. To put this in better perspective, the net income figures can be expressed as a percentage of the sales revenues of each company. Since Wendy’s sales revenues were $2,431 million and McDonald’s were $23,223 million, Wendy’s net income as a percentage of sales was about 0.4% and McDonald’s was about 32.5%. While the comparison still favours McDonald’s, the contrast between the two companies has been placed on a more comparable basis.
THE BALANCE SHEET One application of the vertical analysis idea is to state the separate assets of a company as percentages of total assets. A common-size statement of this type is shown in Exhibit 13–4 for Brickey Electronics.
“How Well Am I Doing?”—Financial Statement Analysis 639
EXHIBIT 13–4 Common-Size Comparative Balance Sheet
BRICKEY ELECTRONICS Common-Size Comparative Balance Sheet December 31, Year 1 and Year 2 (dollars in thousands)
Common-Size Percentages
Year 2
Year 1
Year 2
Year 1
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 Shareholders’ Equity
Current liabilities:
Accounts payable
$ 5,800
$ 4,000
18.4%
13.8%
Accrued payables
900
400
2.8%
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%
Shareholders’ equity:
Preferred shares ($100 par; 20,000 shares issued)
2,000
2,000
6.4%
6.9%
Common shares
(unlimited authorized, $12 par;
500,000 shares issued)
6,000
6,000
19.0%
20.7%
Additional paid-in capital
1,000
1,000
3.2%
3.5%
Total paid-in capital
9,000
9,000
28.6%
31.1%
Retained earnings
8,000
6,970
25.4%
24.0%
Total shareholders’ equity
17,000
15,970
54.0%
55.1%
Total liabilities and shareholders’ equity
$31,500
$28,970
100.0%
100.0%
*Each asset account on a common-size statement is expressed in terms of total assets, and each liability and equity account is expressed in terms of total liabilities and shareholders’ equity. For example, the percentage figure for cash in year 2 is computed as follows: $1,200 ÷
$31,500 =
3.8%.
Note from Exhibit 13–4 that placing all assets in common-size form clearly shows the relative importance of the current assets as compared with the noncurrent assets. It also shows that significant changes have taken place in the composition
of the current assets over the last year. Note, for example, that the receivables have increased in relative importance and that both cash and inventory have declined in relative importance. Judging from the sharp increase in receivables, the deterioration in the cash position may be a result of inability to collect from customers.
THE INCOME STATEMENT Another application of the vertical analysis idea is to place all items on the income statement in percentage form in terms of sales. A common-size statement of this type is shown in Exhibit 13–5. By putting all items on the income statement in common size in terms of sales,
640
Chapter 13
you can see at a glance how each dollar of sales is distributed among the various costs, expenses, and profits. And, by placing successive years’ statements side by side, you can easily spot interesting trends. For example, as shown in Exhibit 13–5, the cost of goods sold as a percentage of sales increased from 65.6% in year 1 to 69.2% in year 2. Or, looking at this from a different viewpoint, the gross margin percentage
declined from 34.4% in year 1 to 30.8% in year 2. Managers and investment analysts often pay close attention to the gross margin percentage, since it is considered a broad gauge of profitability. The
gross margin percentage
is computed as follows:
Gross margin percentage =
Gross margin
Sales
EXHIBIT 13–5 Common-Size Comparative Income Statement
BRICKEY ELECTRONICS Common-Size Comparative Income Statement For the Years Ended December 31, Year 1 and Year 2 (dollars in thousands)
Common-Size Percentages
Year 2
Year 1
Year 2
Year 1
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%
Operating expenses:
Selling expenses
7,000
6,500
13.5%
13.5%
Administrative expenses
5,860
6,100
11.3%
12.7%
Total operating expenses
12,860
12,600
24.7%
26.2%
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:
The percentage figures for each year are expressed in terms of total sales for the year. For example, the percentage figure for cost of goods sold in year 2 is computed as follows: $36,000 ÷
$52,000 =
69.2%.
The gross margin percentage tends to be more stable for retailing companies than for other service companies and for manufacturers, since the cost of goods sold in retailing excludes fixed costs. When fixed costs are included in the cost of goods sold figure, the gross margin percentage tends to increase and decrease with sales volume. With increases in sales volume, the fixed costs are spread across more units and the gross margin percentage improves.
While a higher gross margin percentage is generally considered to be better than a lower gross margin percentage, there are exceptions. Some companies purposely choose a strategy emphasizing low prices (and hence low gross margins). An increasing gross margin in such a company might be a sign that the company’s strategy is not being effectively implemented.
Common-size statements are also very helpful in pointing out efficiencies and inefficiencies that might otherwise go unnoticed. To illustrate, in year 2, Brickey Electronics’ selling expenses increased by $500,000 over year 1. However, a glance at the common-size income statement shows that on a relative basis, selling expenses were no higher in year 2 than in year 1. In each year, they represented 13.5% of sales.
Common-size balance sheets express each asset account as a percentage of total assets, and each liability and equity account as a percentage of total liabilities and share-
holders’ equity. Common-size income statements express each income statement account as a percentage of sales.
HELPFUL HINT
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“How Well Am I Doing?”—Financial Statement Analysis 641
Ratio Analysis—The Common Shareholder
A number of financial ratios are used to assess how well the company is doing from the standpoint of the shareholders. These ratios naturally focus on net income, dividends, and shareholders’ equity.
Earnings per Share
An investor buys a share in the hope of realizing a return in the form of either dividends or future increases in the value of the share. Since earnings form the basis for dividend payments, as well as the basis for future increases in the value of shares, investors are always interested in a company’s reported earnings per share.
Probably no single statistic is more widely quoted or relied on by investors than earnings per share, although it has some inherent limitations, as discussed below.
Earnings per share
is computed by dividing net income available for common shareholders by the average number of common shares outstanding during the year. “Net income available for common shareholders” is net income less dividends paid to the owners of the company’s preferred shares:
1,
2
Earnings per share =
Net income −
Preferred dividends
Average number of common shares outstanding
Using the data from Exhibits 13–1 and 13–2, we see that the earnings per share figure for Brickey Electronics for year 2 is computed as follows:
$1,750,000 −
$120,000
(500,000 shares +
500,000 shares) /2
= $3.26
LO2
Know Apply
CC2: Compute and interpret financial ratios used to measure common shareholders’ well-being.
The number of common shares outstanding is calculated by taking the dollar amount of common stock shown in the balance sheet and dividing it by the common stock’s par value per share.
HELPFUL HINT
DO ANALYSTS BIAS THEIR EARNINGS FORECASTS?
C
Behavioural bias is part of human life. Research from Penn State University suggests that Wall Street analysts’ earnings per share (EPS) forecasts are intentionally overstated. According to the research, over a 22-year period from 1984 to 2006, the analysts’ aver-
age estimated long-term EPS growth rate was 14.7%, as against an actual average long-
term growth rate of 9.1%. The analysts’ average short-term EPS projection was 13.8%, compared with an actual annual EPS growth rate of 9.8%. The professors who conducted the study claim that “analysts are rewarded for biased forecasts by their employers, who want them to hype stocks so that the brokerage house can garner trading commissions and win underwriting deals.”
More recently, a new study based on a sample of over 1.64 million firm-analyst obser-
vations spanning 33 years of data found that analysts’ “first impressions” are positively associated with their future forecasts. They also find that analysts place greater emphasis on their earliest and most recent experiences compared to intermediate experiences.
The desire to please clients leads analysts to unwittingly amplify the shocks of biased forecasts, inducing prices to deviate further from their fundamental values. The research suggests that analysts are notable in their own right as economic agents, and their role in shaping capital market activities continues to be of interest to researchers of financial markets.
IN BUSINESS
642
Chapter 13
Price–Earnings Ratio
The relationship between the market price of a share and current earnings per share is often quoted in terms of a price–earnings ratio
. If we assume that the current market price for Brickey Electronics’ shares is $40 each, the company’s price–earnings ratio is computed as follows:
Price/earnings ratio =
Market price per share
Earnings per share
=
$40
$3.26
=
12.3
The price–earnings ratio is 12.3; that is, the shares are selling for about 12.3 times their current earnings per share.
The price–earnings ratio is widely used by investors as a general guideline in gauging share values. A high price–earnings ratio means that investors are willing to pay a premium for the company’s shares—
presumably because the company is expected to have higher than average earnings growth. Con-
versely, if investors believe a company’s earnings growth prospects to be limited, the company’s price–earnings ratio will be relatively low. For example, not long ago, the shares of some dot-com companies—particularly those with little or no earnings—were selling at levels that gave rise to unpreced-
ented price–earnings ratios. However, these price–earnings ratios were unsustainable in the long run and the companies’ share prices eventually fell.
Dividend Payout and Yield Ratios
Investors hold shares in a company because they anticipate an attractive return. The return sought is not always dividends. Many investors prefer not to receive dividends, but instead to have the company retain all earnings and reinvest them internally in order to support growth. The shares of companies that adopt this approach, loosely termed growth shares,
may enjoy rapid upward movement in market price. Other investors prefer to have a dependable, current source of income through regular dividend payments. Such investors seek out shares with consistent dividend records and payout ratios.
THE DIVIDEND PAYOUT RATIO The dividend payout ratio
gauges the portion of current earn-
ings being paid out in dividends. Investors who seek growth in market price would like this ratio to be small, whereas investors who seek dividends prefer it to be large. This ratio is computed by relating dividends per share to earnings per share for common shares:
Dividend payout ratio = Dividends per share
Earnings per share
For Brickey Electronics, the dividend payout ratio for year 2 is computed as follows:
$1.20
$3.26
= 36.8
%
There is no such thing as a “right” payout ratio, even though it should be noted that the ratio tends to be similar for companies within a particular industry. Industries with ample opportunities for growth at high rates of return on assets tend to have low payout ratios, whereas payout ratios tend to be high in industries with limited reinvestment opportunities.
THE DIVIDEND YIELD RATIO
The dividend yield ratio
is obtained by dividing the current dividends per share by the current market price per share:
Dividend yield ratio = Dividends per share
Market price per share
The market price for Brickey Electronics’ shares is $40 each, and so the dividend yield is computed as follows:
$1.20
$40
= 3.0
%
“How Well Am I Doing?”—Financial Statement Analysis 643
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 the common shares at the current market price. A low dividend yield ratio is neither bad nor good by itself. As discussed previously, a company may pay out very little in dividends because it has ample opportunities for reinvesting funds within the company at high rates of return.
Return on Total Assets
Managers have both financing and operating responsibilities. Financing responsibilities
relate to how one obtains
the funds needed to provide for the assets in an organization. Operating responsibilities
relate to how one uses
the assets once they have been obtained. Both are vital to a well managed firm. However, care must be taken to separate the two when assessing the performance of a manager. That is, whether funds have been obtained from creditors or from shareholders should not be allowed to influence one’s assessment of how well
the assets have been employed since being received by the firm.
The return on total assets
is a measure of operating performance that shows how well assets have been employed. It is defined as follows:
Return on total assets = Net income +
[Interest expense ×
(1 −
Tax rate)]
Average total assets
AVERAGE TOTAL ASSETS Adding interest expense back to net income results in an adjusted earnings figure that shows what earnings would have been if the assets had been acquired solely by selling shares. With this adjustment, the return on total assets can be compared for companies with differing amounts of debt, or over time for a single company that has changed its mix of debt and equity. Thus, the measurement of how well the assets have been employed is not influenced by how the assets were financed. Note that the interest expense is placed on an after-tax basis by multiplying it by the factor (1 −
Tax rate).
The return on total assets for Brickey Electronics for year 2 is computed as follows (from Exhibits 13–1 and 13–2):
Net income
$ 1,750,000
Add back interest expense: $640,000 ×
(1 –
0.30)
448,000
Total (a)
$ 2,198,000
Assets, beginning of year
$28,970,000
Assets, end of year
31,500,000
Total
$60,470,000
Average total assets: $60,470,000 ÷
2 (b)
$30,235,000
Return on total assets, (a) ÷
(b)
7.3%
Brickey Electronics earned a return of 7.3% on average assets employed over the last year.
Return on Common Shareholders’ Equity
An important reason for operating a corporation is to generate income for the benefit of the common shareholders. One measure of a company’s success in this regard is the return on common shareholders’ equity
, which divides the net income remaining for common shareholders by the average common shareholders’ equity for the year. The formula is as follows:
Return on common shareholders’ equity
= Net income +
Preferred dividends
Average common shareholders’ equity
where
Average common shareholders’ equity
= Average total shareholders’ equity
–
Average preferred shareholders’ equity
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644
Chapter 13
For Brickey Electronics, the return on common shareholders’ equity is 11.3% for year 2, as shown below:
Net income
$ 1,750,000
Deduct: Preferred dividends
120,000
Net income remaining for common shareholders (a)
$ 1,630,000
Average total shareholders’ equity
$16,485,000*
Deduct: Average preferred shareholders’ equity
2,000,000
†
Average common shareholders’ equity (b)
$14,485,000
Return on common shareholders’ equity, (a) ÷
(b)
11.3%
*$15,970,000 +
$17,000,000 =
$32,970,000; $32,970,000 ÷
$2 =
$16,485,000 †
$2,000,000 +
$2,000,000 =
$4,000,000; $4,000,000 ÷
$2 =
$2,000,000
Financial Leverage
Financial leverage
(often called leverage
for short) involves acquiring assets with funds that have been obtained from creditors or from preferred shareholders at a fixed rate of return. If the assets in which the funds are invested are able to earn a rate of return greater
than the fixed rate of return required by the funds’ suppliers, then the company has positive financial leverage
and the common shareholders benefit.
For example, suppose that Bell Media is able to earn an after-tax return of 12% on its broadcasting assets. If the company can borrow from creditors at a 10% interest rate to expand its assets, then the common shareholders can benefit from positive leverage. The borrowed funds invested in the business will earn an after-tax return of 12%, but the after-tax interest cost of the borrowed funds will be only 7% (
=
10% interest rate ×
[1 −
0.30]). The difference will go to the common shareholders.
We can see this concept in operation in the case of Brickey Electronics. Note from Exhibit 13–1 that the company’s bonds payable bear a fixed interest rate of 8%. The after-tax interest cost of these bonds is only 5.6% (
=
8% interest rate ×
[1 −
0.30]). The company’s assets are generating an after-tax return of 7.3%, as we computed earlier. Since this return on assets is greater than the after-tax interest cost of the bonds, leverage is positive, and the difference accrues to the benefit of the common shareholders. This explains, in part, why the return on common shareholders’ equity (11.3%) is greater than the return on total assets (7.3%).
Unfortunately, leverage is a double-edged sword. If assets are unable to earn a high enough rate to cover the interest costs of debt and preferred dividends (
negative financial leverage
), the common shareholder suffers
.
Compare the return on common shareholders’ equity above (11.3%) with the return on total assets computed in the preceding section (7.3%). Why is the return on common shareholders’ equity so much higher? The answer lies in the principle of financial leverage,
which is discussed in the following section.
When the numerator of a financial ratio contains an amount from the income statement and the denominator contains an amount derived from the balance sheet, the denomin-
ator must be expressed as an average. This averaging process is done because the income statement summarizes performance for a period of time, whereas the balance sheet reflects a company’s financial position at a point in time. The average for a balance sheet account is typically computed by taking the account’s beginning balance plus the ending balance and dividing this sum by two.
HELPFUL HINT
“How Well Am I Doing?”—Financial Statement Analysis 645
THE IMPACT OF INCOME TAXES Debt and preferred shares are not equally efficient in gen-
erating positive leverage because interest on debt is tax-deductible, whereas preferred dividends are not. This usually makes debt a much more effective source of positive leverage than preferred shares.
To illustrate this point, suppose that the Nursing Home Corporation of Canada is considering three ways of financing a $100 million expansion of its chain of nursing homes:
1. $100 million from an issue of common shares
2. $50 million from an issue of common shares, and $50 million from an issue of preferred shares bearing a dividend rate of 8%
3. $50 million from an issue of common shares, and $50 million from an issue of bonds bearing an interest rate of 8%
Assuming that the Nursing Home Corporation of Canada can earn an additional $15 million each year before interest and taxes as a result of the expansion, the operating results under each of the three alternatives are shown in Exhibit 13–6.
EXHIBIT 13–6 Leverage From Preferred Shares and Long-Term Debt
Alternatives: $100,000,000 Issue of Securities
Alternative 1: $100,000,000 Common Shares
Alternative 2: $50,000,000 Common Shares; $50,000,000 Preferred Shares
Alternative 3: $50,000,000 Common Shares; $50,000,000 Bonds
Earnings before interest and taxes
$ 15,000,000
$15,000,000
$15,000,000
Less: Interest expense (8% ×
$50,000,000)
—
—
4,000,000
Net income before taxes
15,000,000
15,000,000
11,000,000
Less: Income taxes (30%)
4,500,000
4,500,000
3,300,000
Net income
10,500,000
10,500,000
7,700,000
Less: Preferred dividends (8% ×
$50,000,000)
— 4,000,000
— Net income remaining for common shareholders (a)
$ 10,500,000
$ 6,500,000
$ 7,700,000
Common shareholders’ equity (b)
$100,000,000
$50,000,000
$50,000,000
Return on common shareholders’ equity (a) ÷
(b)
10.5%
13.0%
15.4%
If the entire $100 million is raised from an issue of common shares, then the return to the common shareholders will be only 10.5%, as shown under alternative 1 in the exhibit. If half of the funds are raised from an issue of preferred shares, then the return to the common shareholders increases to 13%, due to the positive effects of leverage. However, if half of the funds are raised from an issue of bonds, then the return to the common shareholders jumps to 15.4%, as shown under alternative 3. Thus, long-
term debt is much more efficient than preferred shares in generating positive leverage. The reason for this is that the interest expense on long-term debt is tax-deductible, whereas the dividends on preferred shares are not.
THE DESIRABILITY OF LEVERAGE Because of leverage, having some debt in the capital structure can substantially benefit the common shareholder. For this reason, most companies today try to main-
tain a level of debt that is considered to be normal within the industry. Many companies, such as commercial banks and other financial institutions, rely heavily on leverage to provide an attractive return on their common shares.
646
Chapter 13
Book Value per Share
Another statistic frequently used in attempting to assess the well-being of the common shareholder is book value per share. Book value per share
measures the amount that would be distributed to the holder of each common share if all assets were sold at their balance sheet carrying amounts (i.e., book values) and if all creditors were paid off. Thus, book value per share is based entirely on historical costs. The formula for computing it is as follows:
Book value per share = Common shareholders’ equity
Number of common shares outstanding
= Total shareholders’ equity −
Preferred shareholders’ equity
Number of common shares outstanding
Total shareholders’ equity (see Exhibit 13–1)
$17,000,000
Deduct preferred shareholders’ equity (see Exhibit 13–1)
2,000,000
Common shareholders’ equity
$15,000,000
The book value per share of Brickey Electronics’ common shares is computed as follows:
$15,000,000
500,000 shares
= $30 per share
If this book value is compared with the $40 market value of Brickey Electronics’ shares, then the shares appear to be somewhat overpriced. However, as we discussed previously, market prices reflect expect-
ations about future earnings and dividends, whereas book value largely reflects the results of events that occurred in the past. Ordinarily, the market value of a share exceeds its book value. For example, in a recent year, Microsoft’s common shares often traded at over four times their book value, and Coca-Cola’s market value was over 17 times its book value.
To illustrate the computation and interpretation of financial ratios that are used to assess the com-
pany’s performance from the standpoint of its shareholders, consider the Canadian fertilizer company Nutrien Ltd. The data set forth below relate to the year ended December 30, 2021. (Averages were computed by adding together the beginning- and end-of-year amounts reported on the balance sheet, and dividing the total by two.)
Net income
$3,153 million
Interest expense
$613 million
Tax rate
23.7%
Average total assets
$48,573 million
Preferred share dividends
$0 million
Average common shareholders’ equity
$15,565 million
Common shares dividends per share
$1.80
Earnings per share
$5.52
Market price per share—end-of-year
$74.85
Book value per share—end-of-year
$1.76
Return on total assets = $3,153 +
[$613 ×
(1 −
0.237)]
$48,573
= 6.8
%
Return on common shareholders’ equity
= $3,153 −
$0
$15,565
=
20.3
%
Dividend payout ratio = $1.80
$5.52
=
32.6%
Dividend yield ratio
= $1.80
$74.85
=
2.4%
The return on common shareholders’ equity of 20.3% is higher than the return on total assets of 6.8%, and therefore the company has positive financial leverage. (About two-thirds of the company’s financing is provided by creditors; the rest is provided by common and preferred shareholders.)
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“How Well Am I Doing?”—Financial Statement Analysis 647
Ratio Analysis—The Short-Term Creditor
Short-term creditors, such as suppliers, want to be repaid on time. Therefore, they focus on the company’s cash flows and on its working capital, since these are the company’s primary sources of cash in the short run.
Working Capital
The excess of current assets over current liabilities is known as working capital
. The working capital for Brickey Electronics is computed as follows:
Working capital =
Current assets −
Current liabilities
Year 2
Year 1
Current assets
$15,500,000
$16,470,000
Current liabilities
7,000,000
5,000,000
Working capital
$ 8,500,000
$11,470,000
LO2
Know Apply
CC3: Compute and interpret financial ratios used to measure short-term creditors’ well-being.
IN BUSINESS
SMALL BUSINESS STRUGGLES TO MANAGE ITS DEBT
D
Growth through expansion of business or product line is typical of the opportunities that small businesses face as they seek to consolidate their position in the marketplace and establish presence. Financing the growth is a major challenge, because you can go to the well only so often before the money dries up. The following experience of a small U.S. company is typical. Chuck Bidwell and Jennifer Guarino bought J.W. Hulme Com-
pany to expand the business into luxury briefcases, backpacks, and handbags. The co-owners planned to grow the company’s catalogue mailing list tenfold to 10,000 house-
holds while doubling its product assortment to 250 items. To finance this growth strategy, the company borrowed more than $2 million, causing its debt-to-equity ratio to jump from 2.94 to 5.53. When the company subsequently sought $250,000 in additional loans to finance its next round of catalogues, lenders were apprehensive. The company’s most recent annual sales of $1.5 million fell $500,000 short of the owners’ projections. Further-
more, inventory levels had ballooned to $1 million, signalling declining demand for the company’s products.
SURVIVING THE ROLLER COASTER OF VOLATILE OIL PRICES
E
The woes of the oil companies in the wake of the precipitous decline in crude oil prices in 2015 as well as the windfall profits after the 2022 price recovery are well documented. When prices declined, companies slashed discretionary capital spending, halted several oil exploration projects, and laid off workers. All these moves were ostensibly to position themselves for a prolonged period during which oil prices were expected to stay low—
below $70 per barrel. While the focus in the news had been on the investment side of the business model, the financial press had also been watching the moves being made on the financing side—moves that had been termed “lower for longer.” In this context, the companies were shedding debt and tapping the market for equity to raise capital. This phenomenon can be understood in terms of the risk the companies are seeking to avoid: low oil prices translate to lower revenues and ultimately less cash to service debt. Inabil-
ity to service debt is serious for the future viability of the business. Selling more shares and offering a greater variety of equity to investors enables the firms to build a cushion of liquidity without relying on debt.
IN BUSINESS
648
Chapter 13
The amount of working capital available to a firm is of considerable interest to short-term creditors, since it represents assets financed from long-term capital sources that do not require near-term repayment.
Therefore, the greater the working capital, the greater the cushion of protection available to short-term creditors, and the greater the assurance that short-term debts will be paid when due.
Although it is always comforting to short-term creditors to see a large working capital balance, a large balance by itself is no assurance that debts will be paid when due. Rather than being a sign of strength, a large working capital balance may simply mean that obsolete inventory is being accumu-
lated. Therefore, to put the working capital figure into proper perspective, it must be supplemented with other analytical work. The following four ratios (the current ratio, the acid-test ratio, the accounts receivable turnover, and the inventory turnover) should all be used in connection with an analysis of working capital.
Current Ratio
The elements involved in the computation of working capital are 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 ratios for year 1 and year 2 are computed as follows:
Year 2
Year 1
$15,500,000 $7,000,000
= 2.21 to 1
$16,470,000 $5,000,000
= 3.29 to 1
Although widely regarded as a measure of short-term debt-paying ability, the current ratio must be interpreted with great care. On the one hand, a declining
ratio, as seen above, might be a sign of a deteri-
orating financial condition. On the other hand, it might be the result of eliminating obsolete inventor-
ies or other stagnant current assets. An improving
ratio might be the result of an unwise stockpiling of inventory, or it might indicate an improving financial situation. In short, the current ratio is useful but tricky to interpret. To avoid a blunder, the analyst must take a hard look at the individual assets and liabilities involved.
The general rule of thumb calls for a current ratio of 2 to 1. This rule is subject to many exceptions, depending on the industry and the firm involved. Some industries can operate quite successfully with a current ratio of slightly over 1 to 1. The adequacy of a current ratio depends heavily on the compos-
ition
of the assets. For example, as we see in the table below, both Worthington Corporation and Greystone Inc. have a current ratio of 2 to 1. However, they are not in a comparable financial condition. Greystone is 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 Corporation
Greystone, 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 to 1
2 to 1
“How Well Am I Doing?”—Financial Statement Analysis 649
Acid-Test (Quick) Ratio
The acid-test (quick) ratio
is a much more rigorous test of a company’s ability to meet its short-term debts. Inventories and prepaid expenses are excluded from total current assets, leaving only the more liquid (or “quick”) assets to be divided by current liabilities:
Acid-test ratio = Cash +
Marketable securities +
Current receivables*
Current liabilities
*Current receivables include both accounts receivable and any short-term notes receivable.
The acid-test ratio is designed to measure how well a company can meet its obligations without having to liquidate or depend too heavily on its inventory. Since inventory may be difficult to sell in times of economic stress, it is generally felt that, to be properly protected, each dollar of liabilities should be backed by at least one dollar of quick assets. Thus, an acid-test ratio of 1 to 1 is usually viewed as adequate.
The acid-test ratios for Brickey Electronics for year 1 and year 2 are computed below:
Year 2
Year 1
Cash (see Exhibit 13–1)
$1,200,000
$2,350,000
Accounts receivable (see Exhibit 13–1)
6,000,000
4,000,000
Total quick assets (a)
$7,200,000
$6,350,000
Current liabilities (see Exhibit 13–1) (b)
$7,000,000
$5,000,000
Acid-test ratio, (a) ÷
(b)
1.03 to 1
1.27 to 1
Although Brickey Electronics has an acid-test ratio for year 2 that is within the acceptable range, an analyst might be concerned about several disquieting trends revealed on the company’s balance sheet. Note in Exhibit 13–1 that short-term debts are rising, while the cash position seems to be deteriorating. Perhaps the weakened cash position is a result of the greatly expanded volume of accounts receivable. One wonders why the accounts receivable have been allowed to increase so rapidly in so brief a time.
In short, as with the current ratio, the acid-test ratio should be interpreted with one eye on its basic components.
Accounts Receivable Turnover
The accounts receivable turnover
is a rough measure of how many times a company’s accounts receivable have been turned into cash during the year. It is frequently used in conjunction with an analysis of working capital, since a smooth flow from accounts receivable into cash is an important indicator of the quality of a company’s working capital and is critical to the company’s ability to operate. The accounts receivable turnover is computed by dividing sales on account (that is, credit sales) by the average accounts receivable balance for the year:
Accounts receivable turnover = Sales on account
Average accounts receivable balance
Assuming that all sales for the year were on account, the accounts receivable turnover for Brickey Electronics for year 2 is computed as follows:
Sales on account
Average accounts receivable balance
= $52,000,000
$5,000,000*
=
10.4 times
*$4,000,000 +
$6,000,000 =
$10,000,000; $10,000,000 ÷
2 =
$5,000,000 average
The turnover figure can then be divided into 365 to determine the average number of days being taken to collect an account (known as the average collection period
):
Average collection period = 365 days
Accounts receivable turnover
The average collection period for Brickey Electronics for year 2 is computed as follows:
365 days
10.4 times
= 35 days
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650
Chapter 13
This simply means that, on average, it takes 35 days to collect on a credit sale. Whether the average of 35 days taken to collect an account is good or bad depends on the credit terms Brickey Electronics is offering its customers. If the credit terms are 30 days, then a 35-day average collection period would usually be viewed as very good. Most customers will tend to withhold payment for as long as the credit terms will allow and may even go over a few days. This factor, added to ever-present problems with a few slow-paying customers, can cause the average collection period to exceed normal credit terms by a week or so and should not cause great alarm.
On the other hand, if the company’s credit terms are 10 days, then a 35-day average collection period is worrisome. The long collection period may result from many old unpaid accounts of doubtful collect-
ability, or it may be a result of poor day-to-day credit management. The firm may be making sales with inadequate credit checks on customers, or perhaps no follow-ups are being made on slow accounts.
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 on hand:
Inventory turnover ratio = Cost of goods sold
Average inventory balance
The average inventory figure is the average of the beginning and ending inventory figures. Since Brickey Electronics has a beginning inventory of $10,000,000 and an ending inventory of $8,000,000, its average inventory for the year is $9,000,000. The company’s inventory turnover ratio for year 2 is computed as follows:
Cost of goods sold
Average inventory balance
= $36,000,000
$9,000,000
=
4 times
The number of days being taken to sell the entire inventory one time (called the average sale period
) can be computed by dividing 365 by the inventory turnover figure:
Average sale period = 365 days
Inventory turnover
= 365 days
4 times
=
91
1
4
days
The average sale period varies from industry to industry. Grocery stores tend to turn their inventory over very quickly, perhaps as often as every 12 to 15 days. On the other hand, jewellery stores tend to turn their inventory over very slowly, perhaps only a couple of times each year.
If a firm has a turnover that is much slower than the average for its industry, then it may have obsolete goods on hand, or its inventory stocks may be needlessly high. Excessive inventories tie up funds that could be used elsewhere in operations. Managers sometimes argue that they must buy in very large quantities to take advantage of the best discounts being offered. But these discounts must be carefully weighed against the added costs of insurance, taxes, financing, and risks of obsolescence and deterioration that result from carrying added inventories.
Inventory turnover has been increasing in recent years as companies have adopted just-in-time (JIT) methods. Under JIT, inventories are purposely kept low, and thus a company utilizing JIT methods may have a high inventory turnover as compared with other companies. Indeed, one of the goals of JIT is to increase inventory turnover by systematically reducing the amount of inventory on hand.
The information in the table that follows relates to two companies, Mackey Corporation and Crocus Corporation. In addition to the information in the table, assume the following:
a. On average, 60% of Mackey’s sales are on credit; for Crocus, this ratio is 40%.
b. Numbers presented in the table below are reasonably steady year-over-year for the last four years.
WORKING IT OUT
“How Well Am I Doing?”—Financial Statement Analysis 651
Required
:
Compute all the ratios that short-term creditors are most likely to use to guide their analysis of Mackey Corporation and Crocus Corporation.
A
B
C
D
E
F
G
1
MACKEY CORPORATION
2
Selected Financial Data
3
Assets and Liabilities as at December 31, 2024; Income Statement Data for the Year Ended December 31, 2024
4
5
Current Assets:
Current Liabilities:
6
Cash
$ 386,000
7
Accounts receivable, net
245,600
Accounts payable
$ 176,800
8
Inventory
458,000
Accrued payables
355,600
9
Prepaid expenses
12,500
Notes payable, short-term
86,700
10
$1,102,100
$ 619,100
11
12
Sales
$6,348,800
13
Cost of goods sold
4,965,800
14
Gross margin
$1,383,000
15
16
17
CROCUS CORPORATION
18
Selected Financial Data
19
Assets and Liabilities as at December 31, 2024; Income Statement Data for the Year Ended December 31, 2024
20
21
Current Assets
Current Liabilities:
22
Cash
$1,836,000
23
Accounts receivable, net
764,500
Accounts payable
$2,176,800
24
Inventory
354,000
Accrued payables
855,600
25
Prepaid expenses
121,600
Notes payable, short-term
578,600
26
$3,076,100
$3,611,000
27
28
Sales
$9,634,800
29
Cost of goods sold
5,647,800
30
Gross margin
$3,987,000
SOLUTION TO WORKING IT OUT
The ratios are presented in the table; detailed calculations are shown below the table for Mackey Corporation. A quick comparison based on the ratios suggests that even though Crocus has a higher gross margin, Mackey Corporation is a better performer with respect to four out of six ratios listed below. Crocus is a better performer in terms of inventory turnover and average sale period.
A
B
C
D
1
2
3
Mackey
Crocus
4
652
Chapter 13
A
B
C
D
5
Working capital
$483,000
$(534,900)
6
Current ratio
1.8
0.9
7
Acid-test (quick) ratio
1.0
0.7
8
Accounts receivable turnover
15.5
5.0
9
Average collection period
23.5
72.4
10
Inventory turnover
10.8
16.0
11
Average sale period
33.7
22.9
12
Working capital =
$1,102,100 −
$619,100 =
$483,000
Current ratio
= Current assets
Current liabilities
= $1,102,100
$619,800
≈
1.8
Acid-test ratio
= Cash +
Marketable securities +
Current receivables
Current liabilities
= $386,000 +
$245,000
$619,800
≈
1.0
Accounts receivable turnover
= Sales on account
Average accounts receivable balance
= 60% ×
$6,348,800
$245,600
≈
15.5 times
Average collection period
= 365 days
Accounts receivable turnover
= 365 days
15.5 times
≈
23.5 days
Inventory turnover ratio
= Cost of goods sold
Average inventory balance
= $5,647,800
$458,000
≈
10.8
Average sale period
= 365 days
Inventory turnover
= 365 days
10.8 times
≈
33.7 days
WORKING CAPITAL: A KEY WEAPON FOR BUSINESS VIABILITY
F
Business viability is whether a business is able to survive from one operating cycle to the next. “Survive” means that the company has collected its receivables, converted short-
term assets to cash, and paid off its payables such as supplier credit and interest obliga-
tions, and has cash to fund the operations of the next cycle. Poor management of working capital can result in financial waste in terms of locking up liquidity and constraining strategic initiatives. And, in increasingly uncertain times, tracking and managing financial performance embodied by working capital is a key to ensuring business success. However, this insight might not be receiving adequate attention from business managers. Consider this interesting result from a study conducted by PwC: “If all the companies in our study were to improve their working capital efficiency to the level of the next per-
formance quartile, this would represent a cash release of €1.3 trillion. This would be enough for global companies to boost their capital investment by 55%—without needing to access additional funding or put their cash flows under pressure.” Far from being boring, working capital management is a highly interesting and important area of focus for financial and operations managers and, of course, accountants!
IN BUSINESS
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“How Well Am I Doing?”—Financial Statement Analysis 653
VICE-PRESIDENT OF SALES
Although its credit terms require payment within 30 days, your company’s average collection period is 33 days. A major competitor has an average collection period of 27 days. You have been asked to explain why your company is not doing as well as the competitor. You have investigated your company’s credit policies and procedures, and have concluded that they are reasonable and adequate under the circumstances. What rationale would you consider to explain why (1) the average collection period of your company exceeds the credit terms and (2) the average collection period of your company is longer than that of its competitor?
Note to student: See Guidance Answers online.
DECISION POINT
1. Total sales at a store are $1,000,000, and 80% of those sales are on credit. The beginning and ending accounts receivable balances are $100,000 and $140,000, respectively. What is the accounts receivable turnover?
a. 3.33
b. 6.67
c. 8.33
d. 10.67
2. A retailer’s total sales are $1,000,000, and the gross margin percentage is 60%. The beginning and ending inventory balances are $240,000 and $260,000, respectively. What is the inventory turnover?
a. 1.60
b. 2.40
c. 3.40
d. 3.60
Note to student: See Guidance
Answers
online.
CONCEPT CHECK
Ratio Analysis—The Long-Term Creditor
The position of long-term creditors differs from that of short-term creditors in that they are concerned with both the near-term and
the long-term ability of a firm to meet its commitments. They are concerned with the near term, since the interest they are entitled to is normally paid on a current basis. They are concerned with the long term, since they want to be fully repaid on schedule.
Since the long-term creditor is usually faced with greater risks than the short-term creditor is, firms are often required to agree to various restrictive covenants, or rules, for the long-term creditor’s protec-
tion. Examples of such restrictive covenants include the maintenance of minimum working capital levels and restrictions on payment of dividends to common shareholders. Although these restrictive covenants are in widespread use, they are a poor second to adequate future earnings
from the point of view of assessing protection and safety. Creditors do not want to go to court to collect their claims; they would much prefer to base the safety of their claims for interest and eventual repayment of principal on an orderly and consistent flow of funds from operations.
Times Interest Earned Ratio
The most common measure of a firm’s ability to protect the long-term creditor is the times interest earned ratio
. It is computed by dividing earnings before
interest expense and income taxes (i.e., net operating income) by the yearly interest charges that must be met:
Times interest earned ratio = Earnings before interest expense and income taxes
Interest expense
LO2
Know Apply
CC4: Compute and interpret financial ratios used to measure long-term creditors’ well-being.
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654
Chapter 13
For Brickey Electronics, the times interest earned ratio for year 2 is computed as follows:
$3,140,000
$640,000
= 4.9 times
Earnings before income taxes must be used in the computation, since interest expense deductions come before
income taxes are computed. Creditors have first claim on earnings. Only those earnings remaining after all interest charges have been provided for are subject to income taxes.
Generally, earnings are viewed as adequate to protect long-term creditors if the times interest earned ratio is 2 or more. Before making a final judgment, however, it is necessary to look at a firm’s long-term trend
of earnings and evaluate how vulnerable the firm is to cyclical changes in the economy.
Debt-to-Equity Ratio
Long-term creditors are also concerned with keeping a reasonable balance between the portion of assets provided by creditors and the portion of assets provided by the shareholders of a firm. This bal-
ance is measured by the debt-to-equity ratio
, which is calculated for Brickey Electronics in the table below:
Debt-to-equity ratio = Total liabilities
Shareholders’ equity
Year 2
Year 1
Total liabilities (a)
$14,500,000
$13,000,000
Shareholders’ equity (b)
$17,000,000
$15,970,000
Debt-to-equity ratio, (a) ÷
(b)
0.85 to 1
0.81 to 1
The debt-to-equity ratio indicates the amount of assets being provided by creditors for each dollar of assets being provided by the owners of a company. In year 1, creditors of Brickey Electronics were providing 81 cents of assets for each $1 of assets being provided by shareholders; the figure increased only slightly to 85 cents by year 2.
Creditors would like the debt-to-equity ratio to be relatively low. The lower the ratio, the greater is the amount of assets being provided by the owners of a company and the greater is the buffer of protection to creditors. By contrast, common shareholders would like the ratio to be relatively high, since, through leverage, common shareholders can benefit from the assets being provided by creditors.
In most industries, norms have developed over the years that serve as guides to firms in their decisions as to the “right” amount of debt to include in the capital structure. Different industries face different risks. For this reason, the level of debt appropriate for firms in one industry is not necessarily a guide to the level of debt appropriate for firms in another.
3. Total assets are $1,500,000, and shareholders’ equity is $900,000. What is the debt-to-equity ratio?
a. 0.33
b. 0.50
c. 0.60
d. 0.67
Note to student: See Guidance
Answers
online.
CONCEPT CHECK
Summary of Ratios and Sources of Comparative Ratio Data
Exhibit 13–7 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.
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“How Well Am I Doing?”—Financial Statement Analysis 655
Exhibit 13–8 contains a sample listing of sources that provide comparative ratio data organized by industry. These sources are used extensively by managers, investors, and analysts in doing comparative analyses and in attempting to assess the well-being of companies. The World Wide Web also contains a wealth of financial and other data. A search engine, such as Yahoo! or Google, can be used to track down information on individual companies. Many companies have their own websites on which they post their latest financial reports and news of interest to potential investors. The System for Electronic Document Analysis and Retrieval (SEDAR) database, in operation since 1997, is a particularly rich source. It can be used by public companies to electronically file securities documents and by individuals to access information about public companies.
EXHIBIT 13–7 Summary of Ratios
Ratio
Formula
Significance
Gross margin percentage
Gross margin ÷
Sales
Broadly measures profitability
Earnings per share (of common shares)
(Net income − Preferred dividends) ÷
Average number of common shares outstanding
Tends to have an effect on the market price per share, as reflected in the price–earnings ratio
Price–earnings ratio
Market price per share ÷
Earnings per share
Shows whether a share is relatively cheap or relatively expensive in relation to current earnings
Dividend payout ratio
Dividends per share ÷
Earnings per share
Shows whether a company pays out most of its earnings in dividends or reinvests the earnings internally
Dividend yield ratio
Dividends per share ÷
Market price per share
Shows the return in terms of cash dividends being provided by a share
Return on total assets
{Net income +
[Interest expense ×
(1 −
Tax rate)]} ÷
Average total assets
Measures how well assets have been employed by management
Return on common shareholders’ equity
(Net income −
Preferred dividends) ÷
Average common shareholders’ equity (Net income − Preferred dividends) ÷
(Average total shareholders’ equity −
Average preferred shareholders’ equity)
When compared with the return on total assets, measures the extent to which financial leverage is working for or against common shareholders
Book value per share
Common shareholders’ equity ÷
Number of common shares outstanding (Total shareholders’ equity −
Preferred shareholders’ equity) ÷
Number of common shares outstanding
Measures the amount that would be distributed to holders of common shares if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off
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
Tests short-term debt-paying ability
Acid-test (quick) ratio
(Cash +
Marketable securities +
Current receivables) ÷
Current liabilities
Tests short-term debt-paying ability without having to rely on inventory
Accounts receivable turnover
Sales on account ÷
Average accounts receivable balance
Measures roughly how many times a company’s accounts receivable have been turned into cash during the year
Average collection period (age of receivables)
365 days ÷
Accounts receivable turnover
Measures the average number of days taken to collect an account receivable
Inventory turnover
Cost of goods sold ÷
Average inventory
Measures how many times a company’s balance of inventory has been sold during the year
Average sale period (turnover in days)
365 days ÷
Inventory turnover
Measures the average number of days taken to sell the inventory one time
Times interest earned
Earnings before interest expense and income taxes ÷
Interest expense
Measures the company’s ability to make interest payments
Debt-to-equity ratio
Total liabilities ÷
Shareholders’ equity
Measures the amount of assets being provided by creditors for each dollar of assets being provided by the shareholders
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656
Chapter 13
EXHIBIT 13–8 Published Sources of Financial Ratios
Source
Content
Almanac of Business and Industrial Financial Ratios.
Wolters Kluwer. Published annually.
An exhaustive source that contains common-size income statements and financial ratios by industry and by size of company within each industry.
Annual Statement Studies.
Robert Morris Associates.
Published annually. See http://www.rmahq.org/
annual-statement-studies/ for definitions and explanations of ratios and balance sheet and income statement data that are contained in the Annual Statement Studies.
A widely used publication that contains common-size statements and financial ratios on individual companies. The companies are arranged by industry.
EBSCO Business Source Premier.
EBSCO Publishing. Database. Updated continuously. See https://www.
ebsco.com/products/research-databases/business-
source-premier.
An exhaustive database of business articles in periodicals useful for both industry and company information. Full text is included from nearly 850 active global non–open access journals; rigorous curation and indexing of 1,160 active global open access journals.
EDGAR (Electronic Data Gathering, Analysis, and Retrieval system).
U.S. Securities and Exchange Commission. Website. Updated continuously. http://
www.edgarcompany.sec.gov/.
An exhaustive database accessible on the World Wide Web that contains reports filed by companies with the SEC. These reports can be downloaded.
D&B Business Directory
Dun & Bradstreet. Published annually. https://www.dnb.com/business-directory/
company-profiles.hoovers_online_inc.320aa3907990c 12a0b35dfeb68f1057b.html
Dun & Bradstreet collects private company financials for more than 23 million companies worldwide.
SEDAR.
Website. Updated daily. http://www.sedar.
com.
An exhaustive database on the World Wide Web that can be used to access public company information in the public domain.
Learning Objectives Summary
LO1 PREPARE FINANCIAL STATEMENTS IN DIFFERENT FORMATS
Financial statements can be prepared using two formats: (1) comparative form and (2) common-size form. A comparative form financial statement involves analyzing financial data over time, such as year-to-year dollar and percentage changes for each line item within a set of financial statements. Such an analysis is also known as horizontal analysis or trend analysis. A common-size statement is one that shows items in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. The preparation of common-size statements is known as vertical analysis.
LO2 COMPUTE VARIOUS FINANCIAL RATIOS TO ASSESS FINANCIAL PERFORMANCE
Users of financial statements often rely upon various ratios related to net income, dividends, and share-
holders’ equity to assess a company’s financial performance. Common shareholders use (1) earnings per share, (2) price–earnings ratio, (3) dividend payout and yield ratio, (4) return on total assets, (5) return on common shareholders’ equity, (6) financial leverage, and (7) book value per share. Short-term creditors usually focus on (1) working capital, (2) current ratio, (3) acid-test (quick) ratio, (4) accounts receivable turnover, and (5) inventory turnover. A long-term creditor may use (1) times interest earned ratio and (2) debt-to-equity ratio to guide decision making.
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“How Well Am I Doing?”—Financial Statement Analysis 657
Application Competency Summary
APPLICATION COMPETENCY
DELIVERABLE
SOURCE DOCUMENTS AND KEY INFORMATION
STEPS
KNOWLEDGE COMPETENCY
Prepare and interpret financial statements in comparative and common-size forms. LO1–CC1
Key Information
Financial information for two or more years in a format that (a) displays the increase/decrease between periods in dollar and percentage terms; (b) displays financial data or items on financial statements as a percentage of a total of which that item is a part
Report/Document
Document containing comparative financial statements and common-size statements
Source Documents
Financial statements (balance sheet and income statement) for two or more years
Required Information
Data on financial statements
A. Horizontal Analysis
1. Place financial statement data for two or more years side by side.
2. Calculate the dollar amount of the change for each item between two years, as well as the percentage change using the earlier year as the base year.
3. Calculate the trend percentages for a selected item by stating several years of data for the item as a percentage of the amount in the base year. B. Vertical Analysis
1. Balance sheet: Select an appropriate total (e.g., total assets) and express each asset item as a percentage of this total.
2. Income statement: Express income statement items as a percentage of total sales.
The role of each financial statement in summarizing specific aspects of the financial health of an organization
The meaning of the various financial items and associated concepts appearing on the financial statements as well as the logic underlying the classification schemes adopted for presentation of financial information (e.g., the meaning of current assets, long-term liabilities, etc.)
Note:
The preceding concepts are typically covered in financial accounting courses in greater detail. An understanding of these concepts is essential for the interpretation of the results of financial analysis.
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658
Chapter 13
APPLICATION COMPETENCY
DELIVERABLE
SOURCE DOCUMENTS AND KEY INFORMATION
STEPS
KNOWLEDGE COMPETENCY
Compute and interpret financial ratios used to measure common shareholders’ well-
being.
LO2–CC2
Key Information
Financial ratios and an interpretation of their values
Report/Document
No specific document
Source Documents
Various accounting records, financial statements, market price information
Required Information Required information can be determined from an inspection of each ratio.
A. The ratios for this category are as follows: • Earnings per share
— Price–earnings ratio
— Dividend payout ratio
— Dividend yield ratio
• Return on common shareholders’ equity
• Return on total assets
• Book value per share
Note:
The formulas for the ratios are not provided here as they are summarized in Exhibit 13–7.
Shareholders are concerned with the following aspects of financial performance: net income, dividends, and their equity in the company. The ratios focus on these aspects of performance.
Compute and interpret financial ratios used to measure short-
term creditors’ well-being.
LO2–CC3
Key Information
Financial ratios focusing on the liquidity position of the company
Report/Document
No specific document
Source Documents
As above
Required Information
As above
1. The ratios for this category are as follows: • Working capital
• Current ratio
• Acid-test (quick) ratio
• Accounts receivable turnover
• Inventory turnover
• Average sale period
Short-term creditors are concerned with the ability of the company to cover current liabilities with current assets and by the ability of the company to convert its receivables to cash, as well as its efficiency in collecting the receivables. A related concern is the effectiveness of the company at realizing value from turning over its inventory.
Compute and interpret financial ratios used to measure long-term creditors’ well-
being.
LO2–CC4
Key Information
Financial ratios focusing on the long-
term liquidity position of the company
Report/Document
No specific document
Source Documents
As above
Required Information
As above
1. The ratios for this category are as follows: • Times interest earned ratio
• Debt-to-equity ratio
Long-term creditors are concerned with the ability of the company to service the debt (i.e., pay interest on the loans taken out) and with the amount of the assets supported by the debt relative to capital provided by shareholders.
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“How Well Am I Doing?”—Financial Statement Analysis 659
Review Problem: Selected Ratios and Financial Leverage
Starbucks Coffee Company is the leading retailer and roaster of specialty coffee in North America, with over 1,600 stores offering freshly brewed coffee, pastries, and coffee beans. Data from recent financial statements are given below:
STARBUCKS COFFEE COMPANY Comparative Balance Sheet (dollars in thousands)
End of Year
Beginning of Year
Assets
Current assets:
Cash
$126,215
$ 20,944
Marketable securities
103,221
41,507
Accounts receivable
17,621
9,852
Inventories
83,370
123,657
Other current assets
9,114
9,390
Total current assets
339,541
205,350
Property and equipment, net
369,477
244,728
Other assets
17,595
18,100
Total assets
$726,613
$468,178
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable
$ 38,034
$ 28,668
Short-term bank loans
16,241
13,138
Accrued payables
18,005
13,436
Other current liabilities
28,811
15,804
Total current liabilities
101,091
71,046
Long-term liabilities:
Bonds payable
165,020
80,398
Other long-term liabilities
8,842
4,503
Total liabilities
274,953
155,947
Shareholders’ equity:
Preferred shares
–0–
–0–
Common shares and additional paid-in capital
361,309
265,679
Retained earnings
90,351
46,552
Total shareholders’ equity
451,660
312,231
Total liabilities and shareholders’ equity
$726,613
$468,178
Note:
The effective interest rate on the bonds payable was about 5%.
STARBUCKS COFFEE COMPANY Comparative Balance Sheet (dollars in thousands)
Current Year
Prior Year
Revenue
$696,481
$465,213
Cost of goods sold
335,800
211,279
Gross margin
360,681
253,934
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660
Chapter 13
STARBUCKS COFFEE COMPANY Comparative Balance Sheet (dollars in thousands)
Current Year
Prior Year
Operating expenses:
Store operating expenses
$210,693
$148,757
Other operating expenses
19,787
13,932
Depreciation
35,950
22,486
General and administrative expenses
37,258
28,643
Total operating expenses
303,688
213,818
Net operating income
56,993
40,116
Gain on sale of investment
9,218
–0–
Plus interest income
11,029
6,792
Less interest expense
8,739
3,765
Net income before taxes
68,501
43,143
Less income taxes (about 38.5%)
26,373
17,041
Net income
$ 42,128
$ 26,102
Required:
For the current year:
1. Compute the return on total assets.
2. Compute the return on common shareholders’ equity.
3. Is Starbucks’ financial leverage positive or negative? Explain.
4. Compute the current ratio.
5. Compute the acid-test (quick) ratio.
6. Compute the inventory turnover.
7. Compute the average sale period.
8. Compute the debt-to-equity ratio.
SOLUTION TO REVIEW PROBLEM
1. Return on total assets:
Return on total assets = Net income +
[Interest expense ×
(1 −
Tax rate)]
Average total assets =
$42,128 +
[$8,739 ×
(1 −
0.385)]
($726,613 +
$468,178)/2 =
8.0% (rounded)
2. Return on common shareholders’ equity:
Return on common shareholders’ equity
= Net income −
Preferred dividends
Average common shareholders’ equity
=
$42,128 −
$0
($451,660 +
$312,231)/2
=
11.0
%
(rounded)
3. The company has positive financial leverage, since the return on common shareholders’ equity (11%) is greater than the return on total assets (8%). The positive financial leverage was obtained from current liabil-
ities and the bonds payable. The interest rate on the bonds is substantially less than the return on total assets.
4. Current ratio:
Current ratio = Current assets
Current liabilities
=
$339,541
$101,091
=
3.36 (rounded)
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“How Well Am I Doing?”—Financial Statement Analysis 661
5. Acid-test (quick) ratio:
Acid-test ratio
= Cash +
Marketable securities +
Current receivables
Current liabilities
=
$126,215 +
$103,221 +
$17,621
$101,091
=
2.44 (rounded)
This acid-test ratio is quite high and provides Starbucks with the ability to fund rapid expansion.
6. Inventory turnover:
Inventory turnover = Cost of goods sold
Average inventory balance
=
$335,800
($83,370 +
$123,657)/2
=
3.24 (rounded)
7. Average sale period:
Average sale period = 365 days
Inventory turnover
=
365 days
3.24
=
113 days (rounded)
8. Debt-to-equity ratio:
Debt-to-equity ratio = Total liabilities
Shareholders’ equity
=
$274,953
$451,660
=
0.61 (rounded)
Questions
13–1
Distinguish between horizontal and vertical analysis of financial statement data.
13–2
What is the basic purpose of examining trends in a company’s financial ratios and other data? What other kinds of comparisons might an analyst make?
13–3
Assume that two companies in the same industry have equal earnings. Why might these companies have different price–earnings ratios?
13–4
Armcor Inc. is in a rapidly growing technological industry. Would you expect the company to have a high or low dividend payout ratio?
13–5
Distinguish between a manager’s financing
and operating
responsibilities. Which of these responsibilities is the return on total assets ratio designed to measure?
13–6
What is meant by dividend yield on a common shares investment?
13–7
What is meant by financial leverage?
13–8
The president of a medium-sized plastics company was recently 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 shareholder in this firm, how would you feel about its policy of not taking on interest-paying debt?
13–9
Why is it more difficult to obtain positive financial leverage from preferred shares than from long-term debt?
13–10
“If a share’s market value exceeds its book value, the share is overpriced.” Do you agree? Explain.
13–11
Weaver Company experiences a great deal of seasonal variation in its business activities. The company’s high point in business activity is in June; its low point is in January. During which month would you expect the current ratio to be highest?
13–12
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.
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662
Chapter 13
The Foundational 15
[LO1 – CC1; LO2 – CC2, 3, 4]
Mei-kwei International’s common stock sold for $3.30 per share at the end of this year. The company paid preferred stock dividends totalling $4,000 and a common stock dividend of $0.55 per share this year. It also provided the following data 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
Preferred stock
$ 40,000
$ 40,000
Common stock, $1 par value
$ 80,000
$ 80,000
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
$ 92,000
Required:
13–1
What is the earnings per share?
13–2
What is the price–earnings ratio?
13–3
What is the dividend payout ratio?
13–4
What is the dividend yield ratio?
13–5
What is the return on total assets (assuming a 30% tax rate)?
13–6
What is the return on common stockholders’ equity?
13–7
What is the book value per share at the end of this year?
13–8
What is the amount of working capital and the current ratio at the end of this year?
13–9
What is the acid-test ratio at the end of this year?
13–10
What is the accounts receivable turnover?
13–11
What is the average collection period?
13–12
What is the inventory turnover?
13–13
What is the average sale period?
13–14
What is the times interest earned ratio?
13–15
What is the debt-to-equity ratio at the end of this year?
Brief Exercises
BRIEF EXERCISE 13–1
Expressing Data in Terms of Trend Percentages [LO1 – CC1]
Warm Sheep Inc. of New Zealand markets woolen products for the burgeoning Asian consumer market. The company’s current assets, current liabilities, and sales have been reported as follows over the last five years (year 5 is the most recent):
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“How Well Am I Doing?”—Financial Statement Analysis 663
Year 5
Year 4
Year 3
Year 2
Year 1
Sales
$NZ2,340,000*
$NZ2,160,000
$NZ2,070,000
$NZ1,980,000
$NZ1,800,000
Cash
$NZ 30,000
$NZ 40,000
$NZ 48,000
$NZ 65,000
$NZ 50,000
Accounts receivable, net
570,000
510,000
405,000
345,000
300,000
Inventory
750,000
720,000
690,000
660,000
600,000
Total current assets
$NZ1,350,000
$NZ1,270,000
$NZ1,143,000
$NZ1,070,000
$NZ 950,000
Current liabilities
$NZ 600,000
$NZ 580,000
$NZ 520,000
$NZ 440,000
$NZ 400,000
*$NZ stands for New Zealand dollars.
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.
BRIEF EXERCISE 13–2
Preparing a Common-Size Income Statement [LO1 – CC1]
A comparative income statement follows for Martine Ltd. of Montreal:
MARTINE LTD. Comparative Income Statement For the Years Ended October 31, Year 1 and Year 2
Year 2
Year 1
Sales
$8,000,000
$6,000,000
Less: Cost of goods sold
4,984,000
3,516,000
Gross margin
3,016,000
2,484,000
Less: Operating 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
Less: Interest expense
94,000
84,000
Net income before taxes
$ 730,000
$ 690,000
Members of the company’s board of directors are surprised to see that net income increased by only $40,000 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.
BRIEF EXERCISE 13–3
Computing Financial Ratios for Common Shareholders [LO2 – CC2]
Comparative financial statements for Weller Corporation for the fiscal year ending December 31 appear below. The company did not issue any new common or preferred shares during the year. A total of 800,000 common shares were outstanding. The interest rate on the bond payable was 12.0%, the income tax rate was 40%, and the dividend per share of common shares was $0.25. The market value of the company’s common shares at the end of the year was $18 each. All of the company’s sales are on account.
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664
Chapter 13
WELLER CORPORATION Comparative Balance Sheet (dollars in thousands)
Year 2
Year 1
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
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable
$ 9,500
$ 8,300
Accrued payables
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
Shareholders’ equity:
Preferred shares
2,000
2,000
Common shares
800
800
Additional paid-in capital
2,200
2,200
Total paid-in capital
5,000
5,000
Retained earnings
29,880
26,660
Total shareholders’ equity
34,880
31,660
Total liabilities and shareholders’ equity
$50,280
$45,960
WELLER CORPORATION Comparative Income Statement and Reconciliation (dollars in thousands)
Year 2
Year 1
Sales
$79,000
$74,000
Cost of goods sold
52,000
48,000
Gross margin
27,000
26,000
Operating expenses:
Selling expenses
8,500
8,000
Administrative expenses
12,000
11,000
Total operating expenses
20,500
19,000
Net operating income
6,500
7,000
Interest expense
600
600
Net income before taxes
5,900
6,400
Less: Income taxes
2,360
2,560
Net income
3,540
3,840
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“How Well Am I Doing?”—Financial Statement Analysis 665
WELLER CORPORATION Comparative Income Statement and Reconciliation (dollars in thousands)
Year 2
Year 1
Dividends to preferred shareholders
120
400
Net income remaining for common shareholders
3,420
3,440
Dividends to common shareholders
200
200
Net income added to retained earnings
3,220
3,240
Retained earnings, beginning of year
26,660
23,420
Retained earnings, end of year
$29,880
$26,660
Required:
Compute the following financial ratios for common shareholders for year 2:
1. Gross margin percentage.
2. Earnings per share of common shares.
3. Price–earnings ratio.
4. Dividend payout ratio.
5. Dividend yield ratio.
6. Return on total assets.
7. Return on common shareholders’ equity.
8. Book value per share.
BRIEF EXERCISE 13–4
Computing Financial Ratios for Short-Term Creditors [LO2 – CC3]
Refer to the data in Brief Exercise 13–3 for Weller Corporation.
Required:
Compute the following financial data for short-term creditors for year 2:
1. Working capital.
2. Current ratio.
3. Acid-test ratio.
4. Accounts receivable turnover (assume that all sales are on account).
5. Average collection period.
6. Inventory turnover.
7. Average sale period.
BRIEF EXERCISE 13–5
Computing Financial Ratios for Long-Term Creditors [LO2 – CC4]
Refer to the data in Brief Exercise 13–3 for Weller Corporation.
Required
Compute the following financial ratios for long-term creditors for year 2:
1. Times interest earned ratio.
2. Debt-to-equity ratio.
Exercises
EXERCISE 13–1
Computing Selected Financial Ratios for Common Shareholders [LO2 – CC2]
Selected financial data from the June 30 year-end statements of Safford Company follow:
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666
Chapter 13
Total assets
$3,600,000
Long-term debt (12% interest rate)
500,000
Preferred shares, $100 par, 8%
900,000
Total shareholders’ 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 shareholders’ equity was $2,200,000. There has been no change in the preferred shares during the year. The company’s tax rate is 30%.
Required:
1. Compute the return on total assets.
2. Compute the return on common shareholders’ equity.
3. Is financial leverage positive or negative? Explain.
EXERCISE 13–2
Computing Selected Financial Data for Short-Term Creditors [LO2 – CC3]
Oslo Forest Products ALS, of Bergen, Norway, had a current ratio of 2 to 1 on June 30. On that date, the company’s assets were as follows (the Norwegian currency is the krone, denoted here by the symbol Kr):
Cash
Kr 90,000
Accounts receivable
Kr300,000
Less: Allowance for doubtful accounts
40,000
260,000
Inventory
490,000
Prepaid expenses
10,000
Plant and equipment, net
800,000
Total assets
Kr1,650,000
Required:
1. What was the company’s working capital on June 30?
2. What was the company’s acid-test (quick) ratio on June 30?
3. The company paid an account payable of Kr40,000 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.
EXERCISE 13–3
Computing Selected Financial Ratios [LO2 – CC2, 3, 4]
The financial statements for Leslo Inc. are as follows:
LESLO INC. Balance Sheet March 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
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“How Well Am I Doing?”—Financial Statement Analysis 667
LESLO INC. Balance Sheet March 31
Liabilities and Shareholders’ Equity
Liabilities:
Current liabilities
$ 50,000
Bonds payable, 10%
80,000
Total liabilities
130,000
Shareholders’ equity:
Common shares, no par (6,000 @ $5)
$ 30,000
Retained earnings
140,000
Total shareholders’ equity
170,000
Total liabilities and equity
$300,000
LESLO INC. Income Statement For the Year Ended March 31
Sales
$420,000
Less: Cost of goods sold
292,500
Gross margin
127,500
Less: Operating 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 as follows: accounts receivable, $25,000; inventory, $60,000. All sales were on account.
Required:
Compute financial ratios as follows:
1. Gross margin percentage.
2. Current ratio.
3. Acid-test (quick) ratio.
4. Debt-to-equity ratio.
5. Accounts receivable turnover in days.
6. Inventory turnover in days.
7. Times interest earned.
8. Book value per share.
EXERCISE 13–4
Computing Selected Financial Ratios for Common Shareholders [LO2 – CC2]
Refer to the financial statements for Leslo Inc. in Exercise 13–3. In addition to the data in these statements, assume that Leslo Inc. paid dividends of $2.10 per share during the year. Also assume that the company’s common shares had a market price of $42 each at the end of the year and there was no change in the number of outstanding common shares 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.
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668
Chapter 13
EXERCISE 13–5
Computing Selected Financial Ratios for Common Shareholders [LO2 – CC2]
Refer to the financial statements for Leslo Inc. in Exercise 13–3. Assets at the beginning of the year totalled $280,000, and the shareholders’ equity totalled $161,600.
Required:
1. Compute the following:
a. Return on total assets.
b. Return on common shareholders’ equity.
2. Was financial leverage positive or negative for the year? Explain.
Problems
PROBLEM 13–1
Preparing Common-Size Statements and Financial Ratios for Creditors [LO1 – CC1; LO2 – CC3, 4]
Skylar Keys organized Keys Computers 10 years ago in order to produce and sell several computer devices on which he had secured patents. Although the company has been fairly profitable, it is now experien-
cing a severe cash shortage. For this reason, it is requesting a $500,000 long-term loan from NS Bank, $100,000 of which will be used to bolster the cash account and $400,000 of which will be used to modernize certain important items of equipment. The company’s financial statements for the two most recent years follow:
KEYS COMPUTERS Comparative Balance Sheet
This Year
Last Year
Assets
Current assets:
Cash
$ 70,000
$ 150,000
Marketable securities
—
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 Shareholders’ Equity
Liabilities:
Current liabilities
$ 800,000
$ 430,000
Bonds payable, 12%
600,000
600,000
Total liabilities
1,400,000
1,030,000
Shareholders’ equity:
Preferred shares, no par ($6; 20,000 shares issued)
250,000
250,000
Common shares, no par (unlimited authorized, 50,000 issued)
500,000
500,000
Retained earnings
850,000
680,000
Total shareholders’ equity
1,600,000
1,430,000
Total liabilities and shareholders’ equity
$3,000,000
$2,460,000
e cel
x CHECK FIGURES
(1e) Inventory turnover this year: 5.0 times
(1g) Times interest earned last year: 4.9 times
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“How Well Am I Doing?”—Financial Statement Analysis 669
KEYS COMPUTERS Comparative Income Statement
This Year
Last Year
Sales
$5,000,000
$4,350,000
Less: Cost of goods sold
3,875,000
3,450,000
Gross margin
1,125,000
900,000
Less: Operating expenses
653,000
548,000
Net operating income
472,000
352,000
Less: Interest expense
72,000
72,000
Net income before taxes
400,000
280,000
Less: Income taxes (30%)
120,000
84,000
Net income
280,000
196,000
Dividends paid:
Preferred dividends
20,000
20,000
Common dividends
90,000
75,000
Total dividends paid
110,000
95,000
Net income retained
170,000
101,000
Retained earnings, beginning of year
680,000
579,000
Retained earnings, end of year
$ 850,000
$ 680,000
Required:
1. To assist the NS Bank in making a decision about the loan, 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 (quick) ratio.
d. The average age of receivables (the accounts receivable at the beginning of last year totalled $250,000).
e. The inventory turnover in days (the inventory at the beginning of last year totalled $500,000).
f. The debt-to-equity ratio.
g. The times interest earned.
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. Comment on the results of your analysis in Requirements (1) and (2) above and recommend whether or not the loan should be approved.
Current ratio
2.5 to 1
Acid-test (quick) ratio
1.3 to 1
Average age of receivables
18 days
Inventory turnover in days
60 days
Debt-to-equity ratio
0.90 to 1
Times interest earned
6.0 times
Return on total assets
13%
Price–earnings ratio
12
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. Assume that the following ratios are typical of firms in the electronics industry:
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670
Chapter 13
PROBLEM 13–2
Computing Financial Ratios for Common Shareholders [LO2 – CC2]
Refer to the financial statements and other data in Problem 13–1. Assume that you are an account executive for a large brokerage house and that one of your clients has asked for a recommendation about the possible purchase of Keys Computers shares. You are not acquainted with the company and, for this reason, wish to do certain analytical work before making a recommendation.
Required:
1. You decide first to assess the well-being of the common shareholders. For both this year and last year, compute the following:
a. The earnings per share. There has been no change in preferred or common shares over the last two years.
b. The dividend yield ratio for common shares. The company’s shares are currently selling for $40 per share; last year, they sold for $36 per share.
c. The dividend payout ratio for common shares.
d. The price–earnings ratio. How do investors regard Keys Computers as compared with other firms in the industry? Explain.
e. The book value per share of common shares. Does the difference between market value and book value suggest that the shares are overpriced? Explain.
2. You decide next to assess the company’s rate of return. Compute the following for both this year and last year:
a. The return on total assets. (Total assets at the beginning of last year were $2,300,000.)
b. The return on common equity. (Shareholders’ equity at the beginning of last year was $1,329,000.)
c. The financial leverage. Is it positive or negative? Explain.
3. Would you recommend that your client purchase Keys Computers shares? Explain.
PROBLEM 13–3
Computing the Effects of Financial Leverage [LO2 – CC2]
Several investors are in the process of organizing a new company. The investors believe that $1,000,000 will be needed to finance the new company’s operations, and they are considering three methods of raising this amount of money.
• Method A:
All $1,000,000 can be obtained through issue of common shares.
• Method B:
$500,000 can be obtained through issue of common shares and the other $500,000 can be obtained through issue of $100 par value, 8% preferred shares.
• Method C:
$500,000 can be obtained through issue of common shares, and the other $500,000 can be obtained through issue of bonds carrying an interest rate of 8%.
The investors organizing the new company are confident that it can earn $180,000 each year before interest and taxes. The tax rate will be 30%.
Required:
1. Assuming that the investors are correct in their earnings estimate, compute the net income that would go to the common shareholders under each of the three financing methods listed above.
2. Using the income data computed in part (1), compute the return on common equity under each of the three methods.
3. Why do methods B and C provide a greater return on common equity than method A? Why does method C provide a greater return on common equity than method B?
PROBLEM 13–4
Computing the Effects of Transactions on Financial Ratios [LO2 – CC3]
Denna Company’s working capital accounts at the beginning of the year follow:
A
B
C
1
Cash
$50,000
2
Marketable securities
30,000
3
Accounts receivable, net
200,000
4
Inventory
210,000
CHECK FIGURES
(1a) EPS this year: $5.20
(1c) Dividend payout ratio last year: 42.6%
CHECK FIGURE
(2) Return on common equity, method A: 12.9%
CHECK FIGURE
(1c) Acid-test ratio: 1.4 to 1
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“How Well Am I Doing?”—Financial Statement Analysis 671
5
Prepaid expenses
10,000
6
Accounts payable
150,000
7
Notes due within one year
30,000
8
Accrued liablities
20,000
9
The Effect on
Transaction
Working Capital
Current Ratio
Acid-Test Ratio
(x) Paid a cash dividend previously declared
None
Increase
Increase
During the year, Denna Company completed the following transactions:
x. Example.
Paid a cash dividend previously declared, $12,000.
a. Issued additional capital shares for cash, $100,000.
b. Sold inventory costing $50,000 for $80,000, on account.
c. Wrote off uncollectible accounts in the amount of $10,000. The company uses the allowance method of accounting for bad debts.
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 (quick) ratio.
2. Indicate the effect of each of the transactions previously given on working capital, the current ratio, and the acid-test (quick) ratio. Give the effect in terms of increase, decrease, or none. Item (x) is given below as an example of the format to use:
Year 3
Year 2
Year 1
Sales trend
128.0
115.0
100.0
Current ratio
2.7:1
2.3:1
2.2:1
Acid-test (quick) ratio
0.8:1
0.9:1
1.1:1
Accounts receivable turnover
9.6 times
10.6 times
12.5 times
Inventory turnover
6.4 times
7.2 times
8.0 times
Dividend yield
7.1%
6.5%
5.8%
Dividend payout ratio
40%
50%
60%
Return on total assets
12.5%
11.0%
9.5%
Return on common equity
14.0%
10.0%
7.8%
Dividends paid per share*
$1.50
$1.50
$1.50
*There have been no changes in common shares outstanding over the three-year period.
PROBLEM 13–5
Interpreting Financial Ratios [LO1 – CC1; LO2 – CC2, 3]
Priscilla Liu is interested in the shares of Wang Exports, Inc. Before purchasing the shares, Liu would like to learn as much as possible about the company. However, all she has to go on is the current year’s (year 3) annual report, which contains no comparative data other than the summary of ratios provided below:
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672
Chapter 13
Liu would like answers to a number of questions about the trend of events in Wang Exports, Inc. over the last three years. Her questions are as follows:
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 shares going up or down?
f. Is the amount of the earnings per share increasing or decreasing?
g. Is the price–earnings ratio going up or down?
h. Is the company employing financial leverage to the advantage of the common shareholders?
LYDEX COMPANY Comparative Income Statement
This Year
Last Year
Sales (all on account)
$15,750,000
$12,480,000
Less: Cost of goods sold
12,600,000
9,900,000
Gross margin
3,150,000
2,580,000
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 Shareholders’ 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
Shareholders’ equity:
Preferred shares, no par ($2.40; 60,000 shares issued)
1,800,000
1,800,000
Common shares, no par (unlimited authorized, 75,000 issued)
6,000,000
6,000,000
Retained earnings
1,800,000
1,320,000
Total shareholders’ equity
9,600,000
9,120,000
Total liabilities and shareholders’ equity
$17,100,000
$14,880,000
PROBLEM 13–6
Performing a Comprehensive Ratio Analysis [LO2 – CC2, 3, 4]
You have just been hired as a loan officer at Slippery Rock Bank. Your supervisor has given you a file containing a request from Lydex Company, a manufacturer of safety helmets, for a $3,000,000, five-year loan. Financial statement data on the company for the last two years follows:
e cel
x CHECK FIGURES
(2a) EPS this year: $9.28
(2b) Dividend yield ratio last year: 3.6%
Required:
Answer each of Liu’s questions using the data previously given. In each case, explain how you arrived at your answer.
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“How Well Am I Doing?”—Financial Statement Analysis 673
LYDEX COMPANY Comparative Income Statement
This Year
Last Year
Less: Operating expenses
1,590,000
1,560,000
Net operating income
1,560,000
1,020,000
Less: Interest expense
360,000
300,000
Net income before taxes
1,200,000
720,000
Less: Income taxes (30%)
360,000
216,000
Net income
840,000
504,000
Dividends paid:
Preferred dividends
144,000
144,000
Common dividends
216,000
108,000
Total dividends paid
360,000
252,000
Net income retained
480,000
252,000
Retained earnings, beginning of year
1,320,000
1,068,000
Retained earnings, end of year
$ 1,800,000
$ 1,320,000
Helen McGuire, who just a year ago was appointed president of Lydex Company, argues that although the company has had a spotty record in the past, it has turned the corner, as evidenced by a 25% jump in sales and by a greatly improved earnings picture between last year and this year. McGuire also points out that investors generally have recognized the improving situation at Lydex, as is shown by the increase in market value of the company’s common shares, which are currently selling for $72 per share (up from $40 per share last year). McGuire feels that, with her leadership and with the modernized equipment the $3,000,000 loan will permit the company to buy, profits will be even stronger in the future. McGuire has a reputation in the industry for being a good manager.
Not wanting to botch your first assignment, you decide to generate all the information that you can about the company. You determine that the following ratios are typical of firms in Lydex Company’s industry:
Current ratio
2.3 to 1
Acid-test (quick) ratio
1.2 to 1
Average age of receivables
30 days
Inventory turnover
60 days
Return on assets
9.5%
Debt-to-equity ratio
0.65 to 1
Times interest earned
5.7
Price–earnings ratio
10
Required:
1. You decide first to assess the rate of return that the company is generating. Compute the following for both this year and last year:
a. The return on total assets. (Total assets at the beginning of last year were $12,960,000.)
b. The return on common equity. (Shareholders’ equity at the beginning of last year totalled $9,048,000. There has been no change in preferred or common shares over the last two years.)
c. The financial leverage. Is it positive or negative? Explain.
2. You decide next to assess the well-being of the common shareholders. For both this year and last year, compute the following:
a. The earnings per share.
b. The dividend yield ratio for common shares.
c. The dividend payout ratio for common shares.
d. The price–earnings ratio. How do investors regard Lydex Company as compared with other firms in the industry? Explain.
e. The book value per share of common shares. Does the difference between market value per share and book value per share suggest that its current share price is a bargain? Explain.
f. The gross margin percentage.
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674
Chapter 13
3. You decide, finally, to assess creditor ratios to determine both short-term and long-term debt-paying ability. For both this year and last year, compute the following:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
d. Average age of receivables. (The accounts receivable at the beginning of last year totalled $1,560,000.)
e. Inventory turnover. (The inventory at the beginning of last year totalled $1,920,000.) Also compute the number of days required to turn the inventory one time (use a 365-day year).
f. Debt-to-equity ratio.
g. Times interest earned.
4. Evaluate the data computed in Requirements (1) to (3), and, using any additional data provided in the problem, make a recommendation to your supervisor as to whether the loan should be approved.
PROBLEM 13–7
Preparing Common-Size Financial Statements [LO1 – CC1]
Refer to the financial statement data for Lydex Company given in Problem 13–6.
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 13–8
Computing the Effects of Transactions on Financial Ratios [LO2 – CC2, 3, 4]
In the right-hand column, certain financial ratios are listed. To the left of each ratio is a business transaction or event relating to the operating activities of Dani Trading Company.
Business Transaction or Event
Ratio
1.
The company declared a cash dividend.
Current ratio
2.
The company sold inventory on account at cost.
Acid-test (quick) ratio
3.
The company issued bonds with an interest rate of 8%. The company’s return on assets is 10%.
Return on common shareholders’ equity
4.
The company’s net income decreased by 10% between last year and this year. Long-term debt remained unchanged.
Times interest earned
5.
A previously declared cash dividend was paid.
Current ratio
6.
The market price of the company’s common shares dropped from 24.5 to 20. The dividend paid per share remained unchanged.
Dividend payout ratio
7.
Obsolete inventory totalling $100,000 was written off as a loss.
Inventory turnover ratio
8.
The company sold inventory for cash at a profit.
Debt-to-equity ratio
9.
Customer credit terms were changed from 2/10, n/30 to 2/15, n/30 to comply with a change in industry practice.
Accounts receivable turnover ratio
10.
A common share dividend was issued on common shares.
Book value per share
11.
The market price of the company’s common shares increased from 24.5 to 30.
Book value per share
12.
The company paid $40,000 on accounts payable.
Working capital
13.
A common share stock dividend was issued to common shareholders.
Earnings per share
14.
Accounts payable were paid.
Debt-to-equity ratio
15.
Inventory on open account was purchased.
Acid-test (quick) ratio
16.
An uncollectible account against the allowance for bad debts was written off.
Current ratio
CHECK FIGURE
(1) Total liabilities this year, 43.9%
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“How Well Am I Doing?”—Financial Statement Analysis 675
Business Transaction or Event
Ratio
17.
The market price of the company’s common shares increased from 24.5 to 30. Earnings per share remained unchanged.
Price–earnings ratio
18.
The market price of the company’s common shares increased from 24.5 to 30. The dividend paid per share remained unchanged.
Dividend yield ratio
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 choice of 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 13–9
Computing Financial Ratios for Common Shareholders [LO2 – CC2]
(
Problems 13–10 and 13–11 delve more deeply into the data presented below. Each problem is independent.
)
Empire Labs Inc. was organized several years ago to produce and market several new miracle drugs. The company is small but growing, and you are considering the purchase of some of its common shares as an investment. The following data on the company is available for the past two years:
EMPIRE LABS INC. Comparative Income Statement For the Years Ended December 31
This Year
Last Year
Sales
$20,000,000
$15,000,000
Less: Cost of goods sold
13,000,000
9,000,000
Gross margin
7,000,000
6,000,000
Less: Operating expenses
5,260,000
4,560,000
Net operating income
1,740,000
1,440,000
Less: Interest expense
240,000
240,000
Net income before taxes
1,500,000
1,200,000
Less: Income taxes (30%)
450,000
360,000
Net income
$ 1,050,000
$ 840,000
EMPIRE LABS INC. Comparative Retained Earnings Statement For the Years Ended December 31
This Year
Last Year
Retained earnings, January 1
$2,400,000
$1,960,000
Add: Net income (above)
1,050,000
840,000
Total
3,450,000
2,800,000
Deduct: Cash dividends paid:
Preferred dividends
120,000
120,000
Common dividends
360,000
280,000
Total dividends paid
480,000
400,000
Retained earnings, December 31
$2,970,000
$2,400,000
CHECK FIGURES
(1a) EPS this year: $4.65
(2a) Return on total assets last year: 14.0%
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676
Chapter 13
EMPIRE LABS INC. Comparative Balance Sheet December 31
This Year Last Year
Assets
Current assets:
Cash
$ 200,000
$ 400,000
Accounts receivable, net
1,500,000
800,000
Inventory
3,000,000
1,200,000
Prepaid expenses
100,000
100,000
Total current assets
4,800,000
2,500,000
Plant and equipment, net
5,170,000
5,400,000
Total assets
$9,970,000
$7,900,000
Liabilities and Shareholders’ Equity
Liabilities:
Current liabilities
$2,500,000
$1,000,000
Bonds payable, 12%
2,000,000
2,000,000
Total liabilities
4,500,000
3,000,000
Shareholders’ equity:
Preferred shares, 8%, $10 par
1,500,000
1,500,000
Common shares, no par (200,000 @ $5)
1,000,000
1,000,000
Retained earnings
2,970,000
2,400,000
Total shareholders’ equity
5,470,000
4,900,000
Total liabilities and shareholders’ equity
$9,970,000
$7,900,000
Required:
1. In analyzing the company, you decide first to compute the earnings per share and related ratios. For both last year and this year, compute the following:
a. The earnings per share.
b. The dividend yield ratio.
c. The dividend payout ratio.
d. The price–earnings ratio.
e. The book value per common share.
f. The gross margin percentage.
2. You decide next to determine the rate of return that the company is generating. For both last year and this year, compute the following:
a. The return on total assets. (Total assets were $6,500,000 at the beginning of last year.)
The company’s common shares are currently selling for $60 per share. Last year the shares sold for $45 per share.
There has been no change in the preferred or common shares outstanding over the last three years.
Dividend yield ratio
3%
Dividend payout ratio
40%
Price–earnings ratio
16
Return on total assets
13.5%
Return on common equity
20%
After some research, you have determined that the following ratios are typical of firms in the pharmaceutical industry:
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“How Well Am I Doing?”—Financial Statement Analysis 677
b. The return on common shareholders’ equity. (Common shareholders’ equity was $2,900,000 at the beginning of last year.)
c. The financial leverage. Is it positive or negative? Explain.
3. On the basis of your work in Requirements (1) and (2), are the company’s common shares an attractive investment? Explain.
PROBLEM 13–11
Preparing Common-Size Financial Statements [LO1 – CC1]
Refer to the data in Problem 13–9. The president of Empire Labs Inc. is deeply concerned. Sales increased by $5 million from last year to this year, yet the company’s net income increased by only a small amount. Also, the company’s operating expenses went up this year, even though a major effort was launched during the year to cut costs.
Required:
1. For both last year and this year, prepare the income statement and the balance sheet in common-size format. Round computations to one decimal place.
2. From your work in Requirement (1), explain to the president why the increase in profits was so small this year. Were any benefits realized from the company’s cost-cutting efforts? Explain.
Required:
1. Compute the following amounts and ratios for both last year and this year:
a. The working capital.
b. The current ratio.
c. The acid-test ratio.
d. The accounts receivable turnover in days.
e. The inventory turnover in days.
f. The times interest earned.
g. The debt-to-equity ratio.
2. Comment on the results of your analysis in Requirement (1).
3. Would you recommend that the loan be approved? Explain.
The following additional information is available on Empire Labs Inc.:
a. All sales are on account.
b. At the beginning of last year, the accounts receivable balance was $600,000 and the inventory balance was $1,000,000.
Current ratio
2.4 to 1
Acid-test (quick) ratio
1.2 to 1
Average age of receivables
16 days
Inventory turnover in days
40 days
Times interest earned
7 times
Debt-to-equity ratio
0.70 to 1
PROBLEM 13–10
Computing Financial Ratios for Creditors [LO2 – CC3, 4]
Refer to the data in Problem 13–9. Although Empire Labs Inc. has been profitable since it was organized several years ago, the company is beginning to experience some difficulty in paying its bills as they come due. Management has approached Security National Bank requesting a two-year, $500,000 loan to bolster the cash account.
Security National Bank has assigned you to evaluate the loan request. You have gathered the following data relating to firms in the pharmaceutical industry:
CHECK FIGURES
(1b) Current ratio this year: 1.92 to 1
(1g) Debt-to-equity ratio last year: 0.61 to 1
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678
Chapter 13
Building Your Skills
THINKING ANALYTICALLY [LO2 – CC2, 3, 4]
Incomplete financial statements for Pepper Industries follow:
e cel
x 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
?
Shareholders’ equity:
Common shares, no par (issued at $5)
?
Retained earnings
?
Total shareholders’ equity
?
Total liabilities and shareholders’ equity
$ ?
PEPPER INDUSTRIES Income Statement For the Year Ended March 31
Sales
$4,200,000
Less: Cost of goods sold
?
Gross margin
?
Less: Operating expenses
?
Net operating income
?
Less: Interest expense
80,000
Net income before taxes
?
Less: 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 common shares 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 fiscal year were as follows:
Accounts receivable
$ 270,000
Inventory
360,000
Total assets
1,800,000
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“How Well Am I Doing?”—Financial Statement Analysis 679
COMMUNICATING IN PRACTICE [LO1 – CC1; LO2 – CC2, 3, 4]
Typically, the market price of a company’s shares takes a beating when the company announces that it has not met analysts’ expectations. As a result, many companies are under a lot of pressure to meet analysts’ rev-
enue and earnings projections. Internet startups that have gone public fall into this category. To manage (i.e., to inflate or smooth) earnings, managers sometimes record revenue that has not yet been earned by the company and/or delay the recognition of expenses that have been incurred.
Some examples illustrate how companies have attempted to manage their earnings. On March 20, 2000, MicroStrategy announced that it was forced to restate its 1999 earnings; revenue from multi-year contracts had been recorded in the first year instead of being spread over the lives of the related contracts as required by generally accepted accounting principles (GAAP). On April 3, 2000, Legato Systems Inc. announced that it had restated its earnings; $7 million of revenue had been improperly recorded because customers had been promised that they could return the products purchased. America Online (AOL) overstated its net income during 1994, 1995, and 1996. In May 2000, upon completing its review of the company’s account-
ing practices, the U.S. Securities and Exchange Commission (SEC) levied a fine of $3.5 million against AOL. Just prior to the announcement of the fine levied on AOL, Helane Morrison, head of the SEC’s San Francisco office, re-emphasized that the investigation of misleading financial statements is a top priority for the agency.
Required:
Write a memorandum to your instructor that answers the following questions. Use headings to organize the information presented in the memorandum. Include computations to support your answers, when appropriate.
1. Why would companies be tempted to manage earnings?
2. If the earnings that are reported by a company are misstated, how might this affect business decisions made about that company (such as the acquisition of the company by another business)?
3. What ethical issues, if any, arise when a company manages its earnings?
4. How would investors and financial analysts tend to view the financial statements of a company that has been known to manage its earnings in the past?
ETHICS CHALLENGE [LO2 – CC3, 4]
Venice InLine Inc. was founded by Russ Perez to produce specialized inline skates he designed for doing aerial tricks. Up to this point, Perez has financed the company from his own savings and from retained prof-
its. However, he now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bear-
ings developed just as the company was beginning production for the Christmas season. Perez had been assured by the suppliers that the bearings would be delivered in time to make Christmas shipments, but the suppliers had been unable to make the full delivery. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and had been unable to fill all of the Christmas orders from retailers, causing sales to be below expectations for the year, and Perez now does not have enough cash to pay his creditors.
Required:
Compute the missing amounts on the company’s financial statements. (
Hint:
What is the difference between the acid-test ratio and the current ratio?)
e. Selected financial ratios computed from the statements above for the current year are as follows:
Earnings per share
$2.30
Debt-to-equity ratio
0.875 to 1
Accounts receivable turnover
14.0 times
Current ratio
2.75 to 1
Return on total assets
18.0%
Times interest earned
6.75 times
Acid-test (quick) ratio
1.25 to 1
Inventory turnover
6.5 times
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680
Chapter 13
Well before the accounts payable were to become due, Perez visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Perez that there should not be any problem getting a loan to pay off his accounts payable—provided that on his most recent financial statements 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. Perez promised to return later with a copy of his financial statements.
Perez would like to apply for an $80,000 six-month loan bearing an interest rate of 10% per year. The unaudited financial reports of the company follow:
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 Shareholders’ Equity
Current liabilities:
Accounts payable
$154
$ 90
Accrued payables
10
10
Total current liabilities
164
100
Long-term liabilities
—
—
Total liabilities
164
100
Shareholders’ equity:
Common shares and additional paid-in capital
100
100
Retained earnings
296
282
Total shareholders’ equity
396
382
Total liabilities and shareholders’ equity
$560
$482
VENICE INLINE INC. Income Statement For the Year Ended December 31 (dollars in thousands)
This Year
Sales (all on accounts)
$420
Cost of goods sold
290
Gross margin
130
Operating expenses:
Selling expenses
42
Administrative expenses
68
Total operating expenses
110
Net operating income
20
Interest expense
—
Net income before taxes
20
Less: Income taxes (30%)
6
Net income
$ 14
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“How Well Am I Doing?”—Financial Statement Analysis 681
Required:
1. On the basis of the above unaudited financial statements and the statement made by the loan officer, would the company qualify for the loan?
2. Last year, Perez purchased and installed new, more efficient equipment to replace an older plastic injection moulding machine. Perez had originally planned to sell the old machine but found that it is still needed whenever the plastic injection moulding process is a bottleneck. When Perez discussed his cash flow problems with his brother-in-law, he suggested to Perez that the old machine be sold or at least reclassified as inventory on the balance sheet since 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 Perez concerning the machine?
TEAMWORK IN ACTION [LO1 – CC1; LO2 – CC2, 4]
Gauging the success of a company usually involves some assessment of the firm’s earnings. When evaluating earnings, investors should consider the quality and sources of the company’s earnings, as well as their amount. In other words, the source of the earnings is as important a consideration as the size of the earnings.
Your team should discuss and then respond to the following questions. All team members should agree with and understand the answers (including the calculations supporting the answers) and be prepared to report in class. Each teammate can assume responsibility for a different part of the presentation.
Required:
1. Discuss the differences between operating profits and the bottom line—profits after all revenues and expenses.
2. Do you think a dollar of earnings coming from operations is any more or less valuable than a dollar of earnings generated from some other source below operating profits (e.g., one-time gains from selling assets or one-time writeoffs for charges related to closing a plant)? Explain.
3. What is the concept of operating leverage? What is the relation between operating leverage and operating profits?
4. What is the concept of financial leverage? What is the relation between financial leverage and return on common shareholders’ equity?
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- Qualitative Characteristics The following is a list of qualitativecharacteristics of useful accounting information identified in the FASB'sand the IASB's Statement of Financial Accounting Concepts No. 8 andstatements describing the qualities. A. ComparabilityB. Decision usefulnessC. RelevanceD. Faithful representation E. Predictive valueF. Confirmatory valueG. VerifiabilityH. NeutralityI. Free from error J. ConsistencyK. MaterialityL. TimelinessM. UnderstandabilityN. Completeness _ _ _ _ _ _1. Different knowledgeable and independent observers conreach consensus that a particular representation is faithful_ _ _ _ _ _2. Making information available to decision makers before itloses its capacity to influence decisions._ _ _ _ _ _3. Capacity to make a difference in a decision, enabling users to predict future outcomes and/or confirm prior expectations._ _ _ _ _ _4. Overall objective of financial information. _ _ _ _ _ _ 5. Absence of bias intended to influence financial statementusers'…arrow_forwardFinancial accountingarrow_forwardPROBLEM Below is a list of the qualitative characteristics identified in FASB Statement of Financial Accounting Concepts No. 2. Following the list is a series of descriptive phrases. a. feedback value b. relevance c. decision usefulness d. reliability e. comparability f. predictive value g. varifiability h. consistency i. representational faithfulness j. timeliness k. neutrality _____ 1. When information can make a difference in a decision. _____ 2. Making information available when it is needed. _____ 3. When accounting policies and procedures are unchanged from period ro period. _____ 4. When information is verifiable and neutral. _____ 5. Occurs when the measurement results can be duplicated. _____ 6. The overall qualitative characteristics accounting information should possess. _____ 7. When information enables decision makers to confirm prior expectations. _____ 8. When accounting information is reported the same way by different companies. Required: Match each characteristic…arrow_forward
- Mastery Problem: Financial Statement Analysis Liquidity and Solvency Measures Your friend, another accountant, has bet you that with your knowledge of accounting and just the computations for common analytical measures, you can figure out many aspects of a company's financial statements. You take the bet! Match each computation to one of the liquidity and solvency measures in the table. (Hint: Begin by looking for simple computations and identifying the amounts in those computations. Look for other measures that use those amounts.) Liquidity and Solvency Measures Computations Working capital $3,095,000 – $900,000 Current ratio $3,095,000 ÷ $900,000 Quick ratio $1,866,000 ÷ $900,000 Accounts receivable turnover $8,280,000 ÷ [($714,000 + $740,000) ÷ 2] Number of days' sales in receivables [($714,000 + $740,000) ÷ 2] ÷ ($8,280,000 ÷ 365) Inventory turnover $4,100,000 ÷ [($1,072,000 + $1,100,000) ÷ 2] Number of days' sales in inventory…arrow_forwardMastery Problem: Financial Statement Analysis Liquidity and Solvency Measures Your friend, another accountant, has bet you that with your knowledge of accounting and just the computations for common analytical measures, you can figure out many aspects of a company's financial statements. You take the bet! Match each computation to one of the liquidity and solvency measures in the table. (Hint: Begin by looking for simple computations and identifying the amounts in those computations. Look for other measures that use those amounts.) Liquidity and Solvency Measures Computations Working capital $3,095,000 – $860,000 Current ratio $3,095,000 ÷ $860,000 Quick ratio $1,866,000 ÷ $860,000 Accounts receivable turnover $8,250,000 ÷ [($714,000 + $740,000) ÷ 2] Number of days' sales in receivables [($714,000 + $740,000) ÷ 2] ÷ ($8,250,000 ÷ 365) Inventory turnover $4,100,000 ÷ [($1,072,000 + $1,100,000) ÷ 2] Number of days' sales in inventory…arrow_forwardPROBLEM Below is a list of the qualitative characteristics identified in FASB Statement of Financial Accounting Concepts No. 2. Following the list is a series of descriptive phrases. a. feedback value b. relevance c. decision usefulness d. reliability e. comparability f. predictive value g. varifiability h. consistency i. representational faithfulness j. timeliness k. neutrality _____ 4. When information is verifiable and neutral. _____ 5. Occurs when the measurement results can be duplicated. _____ 6. The overall qualitative characteristics accounting information should possess. _____ 7. When information enables decision makers to confirm prior expectations. _____ 8. When accounting information is reported the same way by different companies. Required: Match each characteristic with the appropiate phrase.arrow_forward
- In chapter 1, we learned about various objectives of financial reporting. Please identify three of these objectivesarrow_forwardwhat student learns about The Accounting Cycle Advanced Accounting for Assets Partnerships and Corporations Financial Analysis and Decision Makingarrow_forwardGive typing answer with explanation and conclusionarrow_forward
- Qualitative Characteristics The following is a list of qualitative characteristics of useful accounting information identified in the FASB's and the IASB's Statement of Financial Accounting Concepts No. 8 and statements describing the qualities. A. Comparability B. Decision usefulness C. Relevance D. Faithful representation E. Predictive value F. Confirmatory value G. Verifiability H. Neutrality I. Free from error J. Consistency K. Materiality L. Timeliness M. Understandability N. Completeness Required: Select the appropriate letter identifying each quality on the statement describing the quality. 1. Different knowledgeable and independent observers can reach consensus that a particular representation is faithful. 2. Making information available to decision makers before it loses its capacity to influence decisions. 3. Capacity to make a difference in a decision, enabling users to predict future outcomes and/or confirm prior expectations. 4. Overall objective of…arrow_forwardThe accounting system should provide information for: Select one: O A. Reporting actual performance to managers O B. Strategic decisions O C. Preparation of financial statements O D. All of the above.arrow_forwardUsing accounting vocabulary Consider the following accounting terms and definitions, and match each term to the definition:arrow_forward
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