Chapter 4, Problem 4.13P

Use of ratios to compare two companies in the same industry

• LO4–10

Presented below are condensed financial statements adapted from those of two actual companies competing in the pharmaceutical industry—Johnson and Johnson (J&J) and Pfizer, Inc. ($ in millions, except per share amounts).

Required:

Evaluate and compare the two companies by responding to the following questions. Note: Because two-year comparative statements are not provided, you should use year-end balances in place of average balances as appropriate.

1. Which of the two companies appears more efficient in collecting its accounts receivable and managing its inventory?

2. Which of the two firms had greater earnings relative to resources available?

3. Have the two companies achieved their respective rates of return on assets with similar combinations of profit margin and turnover?

4. From the perspective of a common shareholder, which of the two firms provided a greater rate of return?

5. From the perspective of a common shareholder, which of the two firms appears to be using leverage more effectively to provide a return to shareholders above the rate of return on assets?

Balance Sheets

($ in millions, except per share data)

	J&J	Pfizer
Assets:
Cash	$ 5,377	$ 1,520
Short-term investments	4,146	0,432
Accounts receivable (net)	6,574	8,775
Inventories	3,588	5,837
Other current assets	3,310	3,177
Current assets	22,995	29,741
Property, plant, and equipment (net)	9,846	18,287
Intangibles and other assets	15,422	68,747
Total assets	$ 48,263	$116,775
Liabilities and Shareholders’ Equity:
Accounts payable	$ 4,966	$ 2,601
Short-term notes	1,139	8,818
Other current liabilities	7,343	12,238
Current liabilities	13,448	23,657
Long-term debt	2,955	5,755
Other long-term liabilities	4,991	21,986
Total liabilities	21,394	51,398
Capital stock (par and additional paid-in capital)	3,120	67,050
Retained earnings	30,503	29,382
Accumulated other comprehensive income (loss)	(590)	195
Less: Treasury stock and other equity adjustments	(6,164)	(31,250)
Total shareholders’ equity	26,869	65,377
Total liabilities and shareholders’ equity	$ 48,263	$116,775
Income Statements
Net sales	$ 41,862	$ 45,188
Cost of goods sold	12,176	9,832
Gross profit	29,686	35,356
Operating expenses	19,763	28,486
Other (income) expense—net	(385)	3,610
Income before taxes	10,308	3,260
Tax expense	3,111	1,621
Net income	$ 7,197	$ 1,639*
Basic net income per share	$2.42	$ 0.22

* This is before income from discontinued operations.

To determine

Financial Ratios

Financial ratios are the metrics used to evaluate the capabilities, profitability, and overall performance of a company.

To Determine: The more efficient company out of the two companies in collecting its accounts receivable, and managing its inventory.

Explanation of Solution

• Accounts receivables turnover ratio

Accounts receivables turnover ratio is mainly used to evaluate the collection process efficiency. It helps the company to know the number of times the accounts receivable is collected in a particular time period. Main purpose of accounts receivable turnover ratio is to manage the working capital of the company. This ratio is determined by dividing credit sales and sales return.

Formula:

$\begin{array}{l}\text{Accounts receivables}\\ \text{ turnover ratio}\end{array}\}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}$

• Average collection period

Average collection period is used to determine the number of days a particular company takes to collect accounts receivables.

Formula:

$\text{Days' sales in receivables}=\frac{\text{Days in accounting period}}{\text{Accounts receivables turnover}}$

• Inventory turnover ratio:

Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.

Formula:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

• Days’ in inventory:

Days’ in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them.

Formula:

$\text{Days' in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}$

Company	Inventory turnover ratio	Average collection period	Inventory turnover ratio	Average days in inventory
J	6.37 times (a)	57 days (c)	3.39 Times  (e)	108  Days (g)
P	5.15 times (b)	71days (d)	1.68 Times (f)	217  Days (h)

                                         (Table 1)

Working Notes:

Calculate the Accounts Receivable turnover ratio for Company J.

$\begin{array}{c}\text{Accounts Receivable Turnover Ratio = }\frac{\text{Net credit sales}}{\text{Average accounts receivable}}\\ \text{ = }\frac{\$41,862}{\text{\$6,574}}\\ \text{ = 6}\text{.37 Times}\\ \end{array}$ (a)

Calculate the Accounts Receivable turnover ratio for Company P.

$\begin{array}{c}\text{Accounts Receivable Turnover Ratio = }\frac{\text{Net credit sales}}{\text{Average accounts receivable}}\\ \text{=}\frac{\$45,188}{\$8,775}\\ \text{=5}\text{.15}\text{times }\end{array}$ (b)

Calculate the Average collection period for J.

$\begin{array}{c}\text{Average collection period = }\frac{\text{Days in accounting period}}{\text{ Receivables turnover}}\\ \\ \text{ J = }\frac{365}{6.37}\\ =57\text{Days}\end{array}$ (c)

Calculate the Average collection period for P.

$\begin{array}{c}\text{Average collection period = }\frac{\text{Days in accounting period}}{\text{ Receivables turnover}}\\ \text{P = }\frac{365}{5.5}\\ =71\text{Days}\end{array}$ (d)

Calculate the inventory turnover ratio for J.

$\begin{array}{c}\text{ Inventory Turnover Ratio = }\frac{\text{Cost of goods sold}}{\text{Average Inventory}}\\ \text{ J = }\frac{\$12,176}{\$3,588}\\ =3.39\text{Times}\end{array}$ (e)

Calculate the inventory turnover ratio for P.

$\begin{array}{c}\text{Inventory Turnover Ratio = }\frac{\text{Cost of goods sold}}{\text{Average Inventory}}\\ \text{P = }\frac{\text{\$9,832}}{\$5,837}\\ =1.68\text{Times}\end{array}$ (f)

Calculate the average days in inventory for J.

$\begin{array}{c}\text{Average days in inventory = }\frac{\text{Days in accounting period}}{\text{Inventory Turnover}}\\ \text{J }=\frac{\text{365}}{\text{3}\text{.39}}\\ =108\text{ Days}\end{array}$ (g)

Calculate the average days in inventory for P.

$\begin{array}{c}\text{Average days in inventory = }\frac{\text{Days in accounting period}}{\text{Inventory Turnover}}\\ \text{P = }\frac{365}{1.68}\\ =217\text{Days}\end{array}$ (h)

Conclusion

• Based on Accounts receivable ratio, the Company J collects their credit receivables within 57 days which is less than 14 days of Company P. Hence, Company J is preferable.
• Based on Inventory turnover ratio, Company J sells its inventory twice more than Company P. Hence, the Company J is preferable.

To determine

The more efficient company out of the two companies, having greater earnings relative resources available.

Explanation of Solution

Return on assets

Return on assetsis calculated by dividing net income by average total sales. It suggests investor, manager how efficient the management is at utilizing its assets to generate earnings.

$\text{Return on assets = }\frac{\text{Net income}}{\text{Total assets}}$

Company	Rate of Return on Assets
J	14.90% (i)
p	1.40% (j)

(Table 2)

Working Notes:

Calculate the Rate of return on assets for J.

$\begin{array}{c}\text{Rate on return of assets = }\frac{\text{Net income}}{\text{Total assets}}\\ \text{ J = }\frac{\text{\$7,197}}{\$48,263}\\ =14.90\%\end{array}$ (i)

Calculate the Rate of return on assets for P.

$\begin{array}{c}\text{Rate on return of assets = }\frac{\text{Net income}}{\text{Total assets}}\\ \text{P = }\frac{\text{\$1,639}}{\$116,775}\\ =1.4\%\end{array}$ (j)

Conclusion

Return on assets reports the overall profitability of the company. In this case, Company J has higher rate of profitability compared to Company P.

To determine

The more efficient company out of the two companies in respective to rates of return on assets with similar combination of profit margin and turnover.

Explanation of Solution

Profit margin

Profit margin on sales is calculated by dividing net income by net sales. It ascertains important dimension of a company’s profitability.

Company	Rate of Return on Assets
J	14.90% (k)
p	1.40% (l)

(Table 3)

Working Notes:

Calculate the Rate of return on assets for J.

$\begin{array}{c}\text{Rate of return on assets = Profit Margin }\times \text{ Asset Turnover}\\ \text{= }\frac{\text{Net income}}{\text{Net sales}}\times \frac{\text{Net sales}}{\text{Total assets}}\\ \text{J }=\frac{\$7,197}{\text{\$41,862}}\times \frac{\text{\$41,862}}{\text{\$48,263}}\\ =\text{}17.19\%\times 0.867\text{Times}\\ \text{=}\text{14}\text{.9\%}\end{array}$ (k)

Calculate the Rate of return on assets for P.

$\begin{array}{c}\text{Rate of return on assets = Profit Margin }\times \text{ Asset Turnover}\\ \text{= }\frac{\text{Net income}}{\text{Net sales}}\times \frac{\text{Net sales}}{\text{Total assets}}\\ \text{P }=\frac{\text{\$1,639}}{\text{\$45,188}}\times \frac{\$45,188}{\text{\$116,775}}\\ =3.63\%\times 0.387\text{Times}\\ \text{=1}\text{.4\%}\end{array}$ (l)

Conclusion

In this case, the profit margin and assets turnover for Company J is comparatively higher than Company P, since the combination of profit margin and assets turnover are not similar. Hence, Company J has higher rate of return on assets.

To determine

The more efficient company out of the two companies, having great rate of return.

Explanation of Solution

Return on shareholders’ equity

Return on shareholders’ equity is calculated by dividing net income by average shareholders’ equity. It reveals the profit of the company generates with the money shareholders’ have invested.

Company	Rate of return on shareholders' equity
J	26.80% (m)
p	2.50% (n)

(Table 4)

Working Notes:

Calculate the Rate of return on shareholders’ equity for J.

$\begin{array}{c}\text{Rate of return on sharedolders' equity = }\frac{\text{Net income}}{\text{Shareholders' equity}}\\ \text{J }=\frac{\$7,197}{\$26,869}\\ =26.8\%\end{array}$ (m)

Calculate the Rate of return on shareholders’ equity for P.

$\begin{array}{c}\text{Rate of return on sharedolders' equity = }\frac{\text{Net income}}{\text{Shareholders' equity}}\\ \text{P }=\frac{\text{\$1,639}}{\$65,377}\\ =\text{}\text{}\text{}\text{}2.5\%\end{array}$ (n)

Conclusion

In this case, Company J provides higher rate of return on shareholders’ equity compared to Company P.

To determine

The more efficient company out of the two companies, having a return to shareholders more than the rate of return on assets.

Explanation of Solution

Equity multiplier shareholders’ equity

Equity multiplier shareholders’ equity is used to measure the company’s financial leverage. It indicates the extent to which a company uses its equity to pay all its assets. If equity multiplier ratio is high it indicates high debt, if the ratio is low it indicates low debt to the company.

$\text{Equity multiplier shareholders equity = }\frac{\text{Total assets}}{\text{Shareholders' equity}}$

Company	Equity multiplier shareholders' equity
J	1.80 (o)
p	1.79 (p)

(Table 5)

Working Notes:

Calculate the equity multiplier shareholders’ equity for J.

$\begin{array}{c}\text{Equity multiplier shareholders' equity = }\frac{\text{Total Assets}}{\text{Sharedolders' equity}}\\ \text{J }=\frac{\text{\$48,263}}{\$26,869}\\ =1.80\end{array}$ (o)

Calculate the equity multiplier shareholders’ equity for P.

$\begin{array}{c}\text{}\text{Equity multiplier shareholders' equity = }\frac{\text{Total Assets}}{\text{Sharedolders' equity}}\\ \text{P =}\frac{\text{\$116,775}}{\text{\$65,377}}\\ =1.79\end{array}$ (p)

Conclusion

In this case, both the companies are having similar equity multipliers, indicating that both the companies are using leverage to certain level to earn return from equity which is higher than return on assets.