56 Part 2 Financin!Analysis and Planning

In the second pafi of the chapter we will explore the impact of inflation and.disin-

flation on financial operations over the last decade. The student begins to appreciate

the impact of rising prices (or at times, declining prices) on the various financial ratios.

The chapter concludes with a discussion of how other factors-in addition to price

changes-may distort the financial statements of the firm. Terms such as net income

ta sales, relurn on .investment. and inventory turnover take on much greater mean-

ing when they are evaluated through the eyes of a financial manager who does more

than merely pick out the top or bottom line of an income statement. The examples inthe chapter are designed from the viewpoint of a financial manager (with only minor

attention to accounting theory).

*a€** &xxm$gw&*

mwDsn & Eradstreet

Ratios are used in much of our daily life. We btry cars based on miles per gallon; we

evaluate baseball players by earned run and batting alerages, basketball players by

fleld goal and foul-shooting percentages, and so on. These are all ratios constructed to

judge comparative performance. Financial ratios serve a similar purpose, but you must

know what is being measured to construct a ratio and to understand the signiflcance ofthe resultanl number.

FiUancial ratios are used to weigh and evaluate the operating performance ofthe firr_n. While an absolute value such as earnings of $50,000 or accounts receiv-

able of $100,000 may apper satisfactory, its acceptability can be measured onlyin relation to other values. For this reason, financial managers emphasize ratio

analysi s.

For example, are. earnlngs of $50,000 actually good? If we earned $50,000 on

$500,000 of sales 110 pdrbent "profit margin" ratio), that might be quite satisfactory-whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent

return). After we have computed the appropriate ratio, we must compare our results

to those achieved by similar firms in our industry, as well as to our own performance

record. Even then, this "number-crunching" process is not fully adequate, and we are

forced to supplement our financial findings with an evaluation of company manage-

ment, physical facilities, and numerous other factors.

For comparative purposes, a number of organizations provide industry data. For

example, Dun & Bradstreet compiles data on 800 different lines of business, whileRobert Morris Associates provides ratios on over 150 industry classifications. Often

the most vaiuable industry figures come from the various trade organizations to which

firms belong (for example, the National Retail Furniture Association or the National

Hardware Association).'Many

libraries and universities subscribe to financial services such as Standard &Poor's Industry Surveys and Corporate Reports, the Value Line Investment Survey,

ald \Ioody's Corporation. Standard & Poor's also leases a computer database calledCompustat to banks, colporations, investment organizations, and universities. Compu-stat roc:ains hnancial statement data on over 16,000 companies for a2}-year period.

R3IiLas .ejl also be found on such Internet Web sites as iitt;t::tj*.!i:i:ll.cr;tlr. These data

:;r Le ;sed tbr countless ratios to measure corporate performance. The ratios used inth:s ierr are a sample of the major ratio categories used in business, but other classifr-caaln srstern,s can also be constructed.

Classification SYstem

I\': ;rli sipara:e --- !--

A. Profitabihr-v ran'1 D-i- tr:-lI. I rL'rr' GE-

-. l('tu-l- --i-

--- tail!-! --'

B- Assetmilizam' P;g31r =':a \- r--,-> ----- -1r r_+:e ! -

5- hrer:.-l-: .

-. F:le: -":

! T'lr-:' a-:=:

G Lqndilyrerct9. Ci:::E:::=

;,fr- Q-i-:r. :=

D- DeHlmir7ff, i )er::; -':

- -. l=:s li:'

1-: . F' r:c ;:';

T-:e l-: ---a--'l:''=;aioearnnl@rl:-:-3ES firrr-3' -- -.-.-i neiteaiwt"v r

r-*,tt' Llde: -l-t le- ^ --- ----'t :rl- ::-.'-.':

-'arrc5eistt,55.fr6receilS:;; :: itei L:s<:*r :

,::j--E L' --':;1 tf,in.@rii-lardlitaFtslm(

-1-:: :se:= ;: :-r':-:_=1r;;; -

-a ----

- --:.*-J_- -- _--

-- - i:^_

---*-r:--___

-- =-'-:-:'.::--'' :-l':1-:tt:::. : ::r=: '-: :- '

. -- -i -i--:-:-.'-1-' I L

t,:.--. r: :-i: -'

,-: --:!--: _--

: t_

:---:: !'-: 3 ;"-ie r

Chapter 3 Financial Analysis

Classification $ystern

We will separate 13 significant ratios into four primary categories.

A. Profitability ratios.

1. Profit margin.

2. Return on assets (investment).

3. Return on equity.

B. Asset utilization ratios.

4. Receivable tumover.

5. Average collection period.

6. Inventory tumover.

7. Fixed asset turnover.

8. Total asset tumover.

C. Liquidity ratios.

9. Currenl. ratio.

10. Quick ratio.

D. Debt utilization r4tios.

11. Debt to total assets.

12. Times interest earned.

13. Fixed charge coverage. iThe first grouping, the pru{iiuirilit-r ratios, allows us to measure the ability of the

irm to earn an adequate return on sales.-total assets, and invested capital. Many ofthetroblems related to profitability can 6r! explained, in whole or in part, by the firm's:bility to effectively employ its resources. Thus the next category is cxsset w**lisatiqil.lulios. Under this heading, we measure the speed at which the firm is tuming over*.counts receivable, inventory, and longer-term assets. In other words, asset utilization

=!ios measure how many times per year a company sells its inventory or collects all of,,5 accounts receivable. For long-term assets, the utilization ratio teils us how produc-:r-e the fixed assets are in terms of generating sales.

[n category C, the lirylidit3'rafiosn the primary emphasis moves to the firm's ability to:ay off short-term obligations as they come due. ln category D, etrebt xxfilipx*i**r nati<x, the

-n;erall debt position of the frm is evaluated in light of its assot base and earning power.The users of financial statements will attach different degrees of importance to

:s rbur categories of ratios. To the potential investor or security analyst, the critical:'nsideration is profitability, with secondary consideration given to such matters as

-:quidity and debt utilization. For the banker or trade creditor, the emphasis shifts toc frrm's current ability to meet debt obligations. The bondholder, in turn, may be:u',marily influenced by debt to total assets-whiie also eyeing the profitability of the::rrr in ternis of its ability to cover debt obligations. Of course, the experienced analystrr:ks at all the ratios, but with different degrees of attention.

R.atios are also important to people in the various functional areas of a business.lle marketing manager, the head of production, the human resource manager, andi.: ,x. must all be familiar with ratio analysis. For exampie, the marketing manageran:st keep a close eye on inventory turnover; the production manager must evaluate

57

:ion and disin-s to appreciate

inancial ratios.

didon to price

a: net incomegreater mean-rho does more

re examples inirh only minor

per gallon; we

>al1 players byconstructed to

:. Lrut you must

significance of

erformance of;ounts receiv-:ea.ured onlynphasize ratio

ed 550.000 on

: sarisfactory-*ger 1 percent

tare our results

r 5rrformancea;e. ard we are

1i.3rlv manage-

ustn data. Forr:siness. whilei.'adons, Oftenaicns to whichor ihe \ational

$ S-andard &s'.n3nt sun-eI.d.a=base calledr:i:ies. ComPu-'r-L\-ear period.

. These data

e :atios used ilr arher classifi-

58 Part 2 Financial Analysis awl Planning

the return on assets; and the human resource manager must look at the effect of "fringebenefits" expenditures on the return on sales.

Ytu* &xa€ga&x

Definitions alone carry little meaning in analyzing or dissecting the financial perfor-mance of a company. For this reason, we shall apply our four categories of ratios to ahypothetical firm, the Saxton Company, as presented in Thble 3-1. The use of ratio anal-ysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

. : ,::',: , : , '.:i:rr'l,:,.!t We first look at profitabilitl,-ratios. The appropriate ratio is com_puted for the saxton company and is then compared to representative industry data.

Financial statement

for ratio analysis

2. Relurn on assets (inveslment) :Net incomea._Total assets

. Net income Sales

Sales Total assets

=-:-* - 12'5Y"

5o/ox2.5:12.5%

ffi=20%0.125 _ 2076

I - U.J/3

Chapter3 FinancialAnalysis

lndusry Average

6.7%

10%

6.77ox 1.5:1Ook

15%

0,10

1 - 0.33

59

Profitabililv ftsirclh -

Saxton Company. Net incomel. Hrolll'marqln = 5.k" Sales

. :€::: :-

3. Return on equity =

Net incomea.

Stockholders' equity

b Retum on assets (rnvestment)

(1 * DebVAssets)

In analyzing the profitabilify ratios, we see the Saxton Company shows a lowerfeturn on the sales dollar (5 percent) than the industry average of 6.7 percent. How-ever, its return on assets (investment) of 12.5 percent exceeds the industry norn ofr0 percent. There is only one possible explanation for this occuffence-a more rapid:r.rrnover of assets than that generally found within the industry. This is verified in ratiolb, in which sales to total assets is 2.5 for the Saxton Company and only 1.5 for the:rdustry. Thus Saxton earns less on each sales dollar, but it compensates by tuming.:,ver its assets more rapidly (generating more sales per dollar of assets).

Return on total assets as described through the two components of profit margin:trd asset tumover is part of the *-3* iiqrsi $}'${e,3l: &J r}{tirt\ .

Retum on assets (investment) : Profit margin X Asset tumovei

The Du Pont company was a forerunner in stressing that satisfactory return on assets:ay be achieved through high profit margins or rapid tumover of assets, or a combina-:on of both. We shall also soon observe that under the Du Pont system of analysis, the

-*- of debt may be important. The Du Pont system causes the analyst to examine the;rurces of a company's profitability. Since the profit margin is an income statement

=iio, a high profit margin indicates good cost control, whereas a high asset turnover:a:io demonstrates efficient use of the assets on the balance sheet. Different industries:.r'e different operating and financial structures. For example, in the heavy capital;:rrds industry the emphasis is on a high profit margin with a iow asset turnover-;:ereas in food processing,.the profit margin is low and the key to satisfactory retums:6 total assets is a rapid turnovet of assets.

Equally important to a firm is its return on equity or ownership capital. For the Saxtonl;'mpany, rethrn on equity is 20 percent, verslls an industry norm of 15 percent. Thus

- owners of saxton company are more amply rewarded than are other shareholders in:: rndustry. This may be the result of one or two factors: a high retum on total assets orr lineronS utilization ofdebt or a combination thereof. This can be seen through Equa-:-::- lb, which represents a modified or second version of the Du Pont fbrmula.

::3sents the..! ! Sales:.-1j-F'-:--

l-.'.\. r.ts:

lairE' ai b1 u.,-3

ll p- --

Chapter 3 Firnncia! Analysis

-{s an example of the Du pont analysis, Tabre3-2 compares two well-known depafi_:i€nr store chains, war-Mart and Macy's. rn 2007, upscale Macy's was more profit_::le in terms of profit margins (4.g percent versus 3.3 percent.) However, wal-Mart:ac a 21.6 percent return on equity versus 10.g percent for Macy's. why the reversal-: :erformance? It comes back to the Du pont system of analysis. war-Mart turned: .' ei iis assets 2.7 times a year versus a considerabiy slower 1 . I times for Macy's.-wal-\I;rt was following the philosophy of its rate founder Sam walton: Give the cusromer. aargain in terms of row prices (and row profit margins), but move the merchandise:r'ore quickly. wal-Mart was able to tum a 10w return on sales (profit margin) into a.,lrd return on assets- Furthermore, its higher debt ratio (5g.g percent for wal-Mart':rsus 49.9 percent for Macy's) allowed v/al-Mart to turn its higher return on assets-:io an even higher relative retur, on equity (21.6 percent versus 10.g percent). For':rne hrms a higher debt ratio might indicate additional risk, but for stable wal_M;-':s is not the case.

Finally as a general statement in computing all the profitability ratios, the analystrust be sensitive to the age of the assets. plant and equipment purchased 15 yearsngo may be carried on the books far below its replacement value in an inflationary-onomy. A 20 percent return on assets-purchased in the early 1990s may be inferior:". a 1 5 percent retum on newly purchbsed assets.

& Asset &$t8iix*tie*& K*rti*}ri* The second category of ratios relates to asset utilization,-d the ratios in this category may explain why one firm can turn ovgr its assets more=pidly than another. Notice that all of these ratios relate the balance sheet (assets) to:oe income statement (sales). The Saxton company's rapid tumover of assets is pri_rarily explained in ratios 4, 5,'and 6.

Ass€t Util,aaiis$ Haftss*

Saxton Company

- -:11.4

..:' i; ;:rl: :: l

::r.,1 :, lii I : rrlil.

T:r*::m = to'a

6t

trehle 3*gReturn of Wal-Martversus Macyb usingthe Du Pont method ofanalysis, 2007

4. Receivables turnover :Sales (credit)

Receivables

5. Average collection period :Accounts receivable

*"W oa"V CreO't.SateS

6. Inventory turnover =

Salesl"ventoty

lndustry Average

10 times.

36 days

7 times

60 Part 2 Financial Analysis and Planning

Note the nufnerator, return on assets, is taken from Formula 2, which represents theinitial version of the Du Pont formula (Return on assets : Net income/Sales X Sales/Total assets). Return on assets is then divided by [1 - (Debt/Assets)] to account forthe amount of debt in the capital structure. In the case of the Saxton Company, the

modified version of the Du Pont formula shows:

Retum on equity : Retum on assets (investment)

(1 - Debt/Assets)

l2.5%o : 2OVo| - 0.375

Actually the return on assets of 12.5 percent in the numerator is higher than the

industry average of l0 percent, and the ratio of debt to assets in the denominator of37.5 percent is higher than the industry norm of 33 percent. Please see ratio 3b onpage 59 to confirm these facts. Both the numerator and denominator contribute to a higher

return on equity than the industry average (20 percent versus I 5 percent). Note that if the

frrm had a 50 percent debt-to-assets ratio, retum on equity would go up to 25 percent.l

Retum on equity : Return on assets (invesLment)

(1 - Debt/Assets)

12'57o

l - 0.50

Figure $*tDu Pont analysis

This does not necessarily mean debt is a positive influence, only that it can be used toboost retum on equity. The ultimate goal for the firrn is to achieve maximum valuationfor its securities in the marketpiace, and this goal may or may not be advanced by usingdebt to increase retum on -equity. Because debt represents increased risk, a lower valua-

tion of higher eamings i5 possible.z Every situation must be evaluated individually.You may wish to review Figure 3-1, which illustrates the key points in the Du Pont

system of analysis.

As an example ot irtr

ment store ghain5' \\-:-i

able in terms of Proi - :had a 21.6 Percent r':*-in performance? It ;'-=nu"r it, assets 2'7 dn:'Mart was following tb:

a bargain in terms ot -t

morJquicklY' Wal-\I-sood return on asseli'

iersus 49'9 Percefli ful!

into an even higher re1

some firms a higher de

this is not the case'

FinallY as a generi

must be sensitive to

ago may be carried I

economy. A 20 Perce

to a 15 Percent retul:

B. &$$*t &lt*?ization i

and the ratios in rhr!

raPidlY than anothe:

the income stateEei

marilY exPlaineC;'

Asset Utilizatio'n tu

4e=-.e-reSat= :=€r_-=1."?

,li€-3F li

t,€--3$

lre+:)-,

tf* ,"n*f a be sligirtly different than 25 percent because of changing financial costs with higher debt.'Further discussion ofthis point is presented in Chapter 5, "Operating and Financial Leverage," andChapter 10,''\aluation md Rates of Retum."

fre*rr.gT j

a

62 Part 2 Financial Analysis and Planning

7. Fixed asset turnover :Sales

Fixed assets

8. Total asset turnover =Sales

Total 'dssets

9. Current ratio :Current assets

Current li'abilities

10. Ouick ratio :

Saxton Company

$800"00s

lndustry Average

5.4 times

llekt tllilixation Rat*l

1 1. Debt to lotal asse:

Total debt

Total assets

12. Times interest ear

lncome before ir

--- ktg

13. Fixed charge ccv(

lncome before i

-

Fx(

Ratios for times ir

Company debt is bei

frrms in the indusnl-.before interest and tathe stronger is tbe irinterest and taxes i 55

presented in the uPPe

Fixed charge covt

rather than interest Pi

cial obligation will e

Company has lease o

Thus the total fixed c

income before aI1 Lr'aod taxes (oPeradng

irrco

Leas

t^^^

The frxed charge

5.5 times. The vario'

sions reached in con

valid, though excePt

sidered "good" unle:

which may hurt futur

In summary, &e S

saies dollar bY a raPi

wise use of debt Th'

financial pedormacc

Or-er the course of *and ratio anal.vsis fc

Therefore we look ai

ever, without indusrpicrure.

-

= 2.5 1.stimesqr 6nn anO

saxton coltrects its receivables faster than does the industry. This is shown by thereceivables turnover of 11.4 times versus 10 times for the industry, and in daily termsby the average collection period of 32 days, which is 4 days faster rhan the industrynorm. Please see these numbers in ratios 4 and 5 on page 61. The average collectionperiod suggests how long, on average, customers' accounts stay on the books_ Thesaxton Company has $350,000 in accounts receivable and $4,000,000 in credit sales,which when divided by 360 days yields average daily credit sales of $11,111. Wedivide accounts receivable of $350,000 by average daily credit sales of $ll,11l todetermine how many days credit sales are on the books (32 days).

In addition the firm turns over its inventory 10.8 times per year as cbntrasted withan industry avetage of 7 times.3 This tells us that saxton generates more sales per dol-lar of inventory than the average company in the industry, and we can assume the firmuses very efftcient inventory-itrdering and cost-control methods.

The firm maintains a slightly lower ratio of sales to fixed assets (plant and equip-ment) than does the industry (5 versus 5.4) as shown above. This is a relatively minorconsideration in view of the rapid movement of inventory and accounts receivable.Finally, the rapid tumover of total assets is again indicated (2.5 versus 1.5).

&- L*quXd*ty *ati*s After considering prohtability and asset utilizarion, the analystneeds to examine the iiquidity of the firm. The Saxton Company's liquidity rarios farewell in comparison with the industry. Further analysis might call for a cgsh budget todetermine if the firm can meet each maturing obligation as it comes due.--&i{'*tid!ty ffiat*as*

saxton company Indusrry Average

$80r,tcc$3*0,cc0

: 2.67 2.1

Cunentassets-lnventory $4_3i1,0C0

cunentliabilities I-i - :1'43 1'o

s. !3ckt lj{ll*xatism &xti** The last grouping of ratios, debt utilization, allows theanalyst to measure the prudence of the debt management policies of the firm.

Debt to total assets of 37.5 percent as shown in Equation 1l is slightly above theindustry average of 33 percent, but well within the prudent range of 50 percent or less.

This ratio may also be computed by using "Cost of goods sold" in the numerabr. While this offers some theo-retical advantages in tems of using cost figues in both the numerator and denominator, Dun & Bradstreet andotber eredit reponing agencies generally show tumover using sales in the numerator

iii::.l i,i:r .::l:: l.'r::t::--.',, -

- :'i .o lLt;.. ?,SseLt --

;sia, r.jellt

?otu*isern

i -r139 int8re6l +erfted :lrrcrr-r* heicrle ir:tei'f5,i and t;ixes

- -i":nrcs,

: reit ch,i:0* Ltn\/drtU{

Ilgrry beFjglf "c,jlarJsl3lgglegilixed fihar-E*s

Chapter 3 Financial r\nalysis

g:ext6*eerrlpany indtlsts.y,Awere_qe

= 37.5% 33%

-= ll Ttimes

= :t 5.5 r:il'ilc$

:i :-ir:: i*l 'ii:nec irteresi eameii and i;xeei charge coverage sh{:iw t}rat the saxtein.' :"itt; debt ls heing i;/uli rflan6"geci ij{:}i1lperfi r1:o the ,:letrt 1nefiageuieng of other',i :i.i !i'te indr:stii;. Tirnes ir:i:elesf earraeej nndi6;ates 1he nur,.rhe1 of iirnes tllat income- :';

':iif,r-ilFii anil taxes covers ihe interest c,hligation itr 1- tii::*s).'rile higi:er the raoc,. :t:.,1go! is iile iuteresri-flr)./ing abitiCy ol' .che fir.n" Tlie 1ig.rli.,,. foii= incr,rme bef'oie: .-::t ii!.1 ialies i$ji5tl,00C) r;r t!:* latio is'rire equiv5.l66X of t.ho operaiing 1?r{rflt figilrr.j

: .:ri*d ir:: ihe upirer ilart c,{'I'aiirXe 3--tr, back .}ft page 58.I '.ti charg': coveraga rneasilres lhe firr'n's ahiiitS' X61 rilee!- eli fir"cd obligat_ions' ;: ihajn icterest ila,vtnen'es al6i?e, oi1 the assr,lrrlptiOn that tgiXu1:,e tC #?eet aq3i finall-

,i-;ligation ",vil? enclanger the positiori *f^ the fin:1. xn th* p::esent casl: the $ax-ton: r'?ri' ha$ leiisr': r:bligatilns of $5t),008 es weil ;rs ttrre $ji0,000 in inieresr sxrrsnses.. , .iic ii;tat fixed r,:iraige flna.*ciel *biigaricr rs $100,000. "f/e ;;,iso need {o l<lao'+ ihe.:.; i*fc:L"e ani l1v'ed ctra.rge: cbLip,aticris. I;i rhis cas* we L:jl{e income befcre lnter.osi

. .,rrres (op*t:at.tne profit) and a*o. ba*k the $50,$*{J in j.ease prl_yrftej:its.

inr,cryle b*icli* intBresi :nci lar.e. ,{j55fl,t}ri0

5il,{}*ili,gFr$H Dsliii'r*!'tts

lri(;iln]e bef*rs fix*C ilhs!"ges a!l* i*xes $m0,J.0e rr

-.tr it.tod- *halges ai:f saf'eiij/ coveied 6 tirnes, exeeeding ilre in<lustryr norn1 ofr:i"s. T'ht-, vaiia:1,.: raiir,:sr rj1'e summaftzed- ir'iahle'j'*j, *t-t !:rge i.1 'fhe cor;*,ii.r-

, :*a*hed ir c+iirp*"$ng';he sauoi: corrrpaily i;.1 inilusll-.- a'11.jragaira F,le gefi*i.ali,l,-, ir!.-r!i.gi-i excepiiolls rn;ly exlsi. F*r exanapie" a iris.h irir-,reLriiorv t$rr-rcrrei'is q:on-

-:;i "i1o+cl" unXess i'u Ls ef;iltrl'ed.'by nreirntainlng dnustjali-ri ilrv,r rnirentcii-ii ierrela,... iltz-il iiur,i'; iu-ltt-iie s:lie-q ancJ ;.rlcfitability.' i r]l1il;r5lj/1 i.j:e ;taXtCn t-iOmpU.iry tnOle ijl;:$ itJlijFenSar"tet tCr a lC;r,,er rettl]rui :1fi. thr:'ri-;jls'trlyar"api*i(u'n{ivei:ci'e.s::leis,.qrinclpaiiyix}i/fiurfirlarrrlri:t;,eura"hl*s,a1lda: ,:: o.ir iei-rl.. 'li']t llltu:deni sh.*urLc ile ;.bie r-1, rrsr iilese i3 ixieasuititi,: ii_* rivfiilri:i_3 iite

,-,:rl . e, f,Jl::rlafi(t{:.i aif a'fl..)/ jiiirn.

..il', coutse c{'lilc irii:it'r*lqs cytig, satres anil pfcfiEehilli'?- ma,li +xlranrJ end contiilci,,r.:lj a.nalt",qis flir aia.v ot.-rrJ Vert jrlai/ n{l[ !]realeni an ae*urafe p,icl.*r* ol tfue fij-rn.

:'ii,rf- V,/g I*Cjr a-i, ilie ,lf perf*irnal'lce lr-t'e;i ix liumtrt-:; *f years. tr-1o",v

irr:ut L-nduslrv r:otnp:-i.-isrrir; eve.m tiend anai-,;:;,is i:ruey not pie:teui a r:r:*rrlete

64

?*&*s $**Ratio analysis

ftstlra* 3*A

Trend analysis

Part 2 FinancialAnalysis and Planning

32.0

10,8

5.0

2.5

1.43

37.5y"

6.O

For example. l:

for the Saxton C'

itself may look gt

compared to indur

average. With a::though it is in a d,

By comparingtime. In looking ;

margins and returis primarily due t'

squeeze on profri.Lou Gerstner tociing matters aro'J:l,

all-time highs i-r:

of 2001-2002. ,\thead of the firm, :

Chapter 3 Financial Analysis

For example, in Figure 3-2 at the bottom of page 64, we see that the profir marginfor the Saxton company has improved, while asset turnover has declined. This byitself may look good for the profit margin and bad for asset tumover. However, whencompared to industry trends, we see the firm's profit margin is still below the industryaverage. with asset turnover, saxton has improved in relation to the industry eventhough it is in a downward trend. Similar data could be generated for the other ratios.

By comparing companies in the same industry, the analyst can analyze trends overtime. In looking at the computer industry data in Table 3-4, it is apparent that profitmargins and returns on equity have declined over time, for IBM, Dell, and Apple. Thisis primarily due to intensified cornpetition within the industry. IBM began to feel thesqueeze on profits first, beginning in 1991. and actually lost money in 1993. By 1994,Lou Gerstner took over as chairman and chiefexecutive officer at IBM and began turn-ing matters around; by 1997,IBM was back to its old levels of profitability and hittingall-time highs ior return on stockholders'equity. This conrinued until the recessionof 2001-2002. At the end of 2002, Lou Gerstner announced he was stepping down ashead of the firm. Since then, the company has maintained its profit margins.

Trend analysis in thecomputer industry

:lt:,,:aa:::::l:::::1:

iiriirt:::r::l:l:r::,ll t:::rt: i:li:i::: l::

Margin Equity Margln Equity Margin Equity

i:liii:rr:l:rlr::

1S88 9.8 147 9.8 39.9

ry

rl: x*s*{**r g*gt{f*i'fi

Finencial qnalysis is not onli/ rlone byr manag-ers of tne flrm but by outsice analyst$ as weli.

, Theee outside analysts normally suppiy dat*!o stock market irrvestors.

One of the probiems that was detecred afterihe gieal buli merket of the .f gg0$ vdas ihalanalysts ulere not aiways as obieciir.,e as iherTshould be. This uniortunate cliscorrery heipedintensiiy the bear market of the eariy 200*s.

. The reason that manv analysts lack objec-tivity is that they rruork for irrvesrrnent banking*brokerage firms thai are not onjy invclved in pro-.riding financial analysis for inl,,estors. but alsounderwfiting the sec,.lrilies of ttte {r!,ms they arecovdiing. Underurrlting actirrity involves $e Cis-tribuiion of new securities in the pubrllc rnarhetsand is highly prcfltable to thc investmen, O"-1",For exampie. Goldman Sachs. a ma;or WaliStreer investment bankjng firm. may not orjly bedoing researeh anc financiai anaiysis on Generail"loiors or Eastrnan Kodak, but aisc prolling frominvestment banking business wrth these rirryrs

Since the fees from investmeni banking aCtivi-ties contribute heavily to the overart operaiions otlhe ;nvestment bankcr. nrairy analysrs ior invesi-nrent banking firms -r.eiaxed their standa"cs. Indoing financial analysis on their clients in the1 990s.

As. ari example, Goldrp3n Sachs, MerrilfLynch. or Smilh Barney often fditecl to dlvr,rlgepotential weakiresses in the firn.ts they wereinvestigattng foi fear of tr:sing the cl;snts ;nvest-ment banking business. Corporatiolls ir-lat werebeing r€pcited upon were equaily quihy. lr4anya corporate cnief ofticer totd an inveslrnenl'banker

that "if you come out wiih a negativereport, you will never.see anotfier dollar'$.worthof our invesimeni bankirrg business.' MorganStanley, a ma.i.r investment ba_nket, aotueliyhad a written inlei.nal policy for analysts never

t1 .lq9 negative ccrnment$ atrout iirms pro-vidins jnve$tn'|ent bailkiitg fe€s. Fity ihe poorinvestor who naively followed the advice o,Morgan titanley during the nrri-1ggOs.

After lhe marker crash of the early 2000s,tne SEC antj federai tegislators b,eOan requir-:ng lnve$tment bank€rs to eithei fui,ii separatetheir linancial anaiysis and undern'ritifig busi-noss ot, at a rnintmum, fully divulge an,v sLrchrelaticnships. For example. Merritl Lynch nowstaies in its research teports, "lnvestors shoulcJassume ihat Merriii Llinch is seeking or wiltseek investing banking or other business rela-iionships v./jtn the companies in thjs report,'

The government i.s also requiring invest-rnent bankers to provide independent reports toaccompany thoir own in-house reports. Thesejndependent reports are done by fee-basedresearch firms ihat do not engage in under-urriting actrvrries. Independenitims inclLrJeStandard & Foor's, Value Line, Morningitar,and other srnaller jirrns, Tney tend 1o be totallyobjective and hard-hitting when neces$ary.' Sofie inciependent research iirms kncwmcr'e af,out a company ihan it knows aboutitself. Take the example c'f Sanfcrd C. Bern-stein & So. aird Cisco $ysterrs in late 2000,Bernstein analyst Paul Sagawr Cowng!.adedCisco ior investment purpcses even thoughCis;c Chief Sxeculive Officer John T. Cham,bers respectfutly disagreed. The astute inde-pendent andiysr anticipateci rhe enci cf theteleccm boom and krrely 16u disastrous effeclit would hsve on Cisco because ihe companywoLl,J io$c key lelecom custonrers. When thedisaster finatl]r cceltrrecl, eEO Charxbers toldrnvestors that 'Nc one could nave predicted it.It was like a 100-year ilood. Apparently he for-got about the Sagawa repnrt he had read anddismissed cnly a feiii month$ befc,re.

\:' ::i '* -,- r;: _-:nrr*: i

-_ _a:r:i-rr:r -

B:iore. coin:tr:::.Dlore the lr::,':rS of the i-rr -:-

ihat nla]'misie.:a1d we shali ::,-

The majo: :r:in current dolla::at lower pnc3 :;..satisfacton F.rthe 1990s and ::,should be arr ar;

.rl iliit-lt:rl: "The Stein Ccrp:.end the firm a1s.-

Cross profil. .

Selling and adr rDeBreciation. .

Operating protli.

Taxes (40%) . .

Aftertax income

Assume that :,However, inflaril,-wili go up to Siivolume. Further. .purchased will be .

written off agarnsl

In Table 3-6. r|:shown in Thbie 3-:is the increased cc's

I'i:;.ll:ll.'L:llt,rl.t : . .

As mentioned r:.

the FASB for larg:tary. What are the l

of 10 chemicai firn6d

De1l Conlputer.dic not come iirt$ the pict-ure u*tii 1992, and liacl showil very strongleveis of perf,onnanee r:rltii 200f-r. F**l-lciler I4jcliael Dell, a billionaire, had to onceagain assuma the role as cFiL\ io trl, ic il'prove the cc*pairy's nurrber.s.

The firrn i}:af suffe,red the inost lteady rlectrine was .Apprie colnputer, "\4rith act*aliosses in 1995 and 1997, and a threar cr banki-utrlrcy at thar tiine. !{owever, by 199gApple h*d niiraculously t*rneC itself arr:und ix/ith a lucrative new line of L4aciotosl,lrlesktoxr ecmputers anel its profit mangins *n{: .retilx-ils ou ec}ujty were v,rell inio thehiack: again. Iiowever, .Ag:ptre trlr.r su{'ier*cl during rl:e r€ressiorl of ?00tr*2[J02 lieforereillmiitg l.{} lirofitahilily with tts imrrovrng Frers$nal rorilFlrlter salcs, rts pgpgiar iFocluigii;,ri iriisii: pliayers, and its iFiione !r Zi.l07.

Il

Chapter 3 Financial AnalYsis

What will be the trends for all three companies for the rest of the decade? Technology

is changing so"quickly that no one can say. All three are likely to remain lean in terms

of operating expenses, but highly innovative in terms of new product development.

67

:.- 1:il

:r ui'

! --rEft

{ ::BlF

': {;]@

+ffi

lF.

- :rien"-le T@::at[p!-s $fr@

'r',rg'ft:5m !ffil{}lliffi si.

h1G'ffin W

Before, coincident with, or following the computation of financial ratios, we should

explore the impact of is*!'';rti*:l and other sources of distortion on the financial report-

ur! of tne firm. As illustrated iil this section, inflation causes phantom soulces of profit

':Uat may mislead even the most alert analyst. Disinflation also causes certain problems

and we shall consider these as well'

The major problem during inflationary times is that revenue is almost always stated

:n cuffent dollars, whereas plant and equipment or inventory may have been purchased

3t lower price levels. Thus, profit may be more a function of increasing prices than of

satisfactory performance. Although inflation has been moderate throughout most of

:e 1990s and the current decade, it tends to reappear in almost every decade so you

:rould be aware of its consequences.

ln ii!*stra€;am

lae Stein Corporation shows the accompanying income statement for 2008. At year-

:rd the firm also has 100 units still in inventory at $1 per unit'

,issume that in the yeat 20a9 the number of units sold remains constant at 100.

--.-;. ever, inflation causes a l0 percent increase in price, from $2 to $2.20. Total sales

., ' go up to $220 as shown in Table 3-6, but with no actual increase in physical

t -ne. Further, assume the firm uses FIFO inventory pricing, so that inventory first

::::lased will be written off against current sales. In this case, 2008 inventory will be

,,:::n off against year 20A9 sales revenue.

: Table 3-6, the company appears to have increased profit by $ 1 1 compared to that

,: : . : in Thble 3-5 (from $42 to $53) simply as a result of inflation. But not reflected

-- . :ncreased cost of replacing inventory and plant and equipment. Presumably, their

:iir*xi$, l*i;1s have increased in an inflationary environment'

--j mentioned in Chapter 2, inflation-related information was formerly required by

:* :-{SB for large companies, but this is no longer the case. It is now purely volun-

y -ihat are the implications of this type of inflation-adjusted data? From a study

- - :hemical firms and eight drug companies, using current cost (replacement cost)

&mpa** xx€

$an$8at$wsx gg€x

S*axsm*$*x$

&:aa$ys&w

T*il*le 54

. .,ti,

:

ll

-l

n

in

fl

t

?

qil

{Etlll$l

l!ttiItt'lIiI1

68

Tahle W

}?a&te 3*?

Comparison of rePlace'

ment cost accounting

and hi$torical cost

accounting

Part 2 Financial Analysis and Planning

data found in the financial lOK statements which these companies filed with the Secu-

rities and Exchange commission, it was found that the changes shown in ^fable3-7

occurred in their assets, income, and selected ratios'4

iiiiicls::rrr::t:itrtr:

The comparison of replacement cost and historical cost accounting methods in the

table showsihat replacement cost reduces income but at the same time increases assets'

This increase in assets lowers the debt-to-assets ratio since debt is a monetary asset that

is not revalued because it is paid back in current dollars. The decreased debt-to-assets

ratio would indicate the financial leverage of the firm is decreased, but a look at the

interest coverage ratio tells a different story. Because the interest coverage latio mea-

sures the operating income available to cover interest expense, the declining income

penalizes this ratio and the firm has decreased its ability to cover its interest cost'

f;isiiditrticcr{ frfqe*t

As long as prices continue to rise in an inflationary environment, profits appear to feed

on themselves. The main objection is that when price increases moderate (eiisi*{3*"

tir;x), there will be a rude awakening for management and unsuspecting stockholders

as expensive inventory is charged against softening retail prices. A 15 or 20 percent

nl"ff C"-"U ""0

Ceoffrey A. Hirt, "Replacement Cost Data: A Study of the Chemical and Drug Industry for

v"*, t szo tt .ough 1 978." Replacement cost is but one form of cunent cost. Nevertheless, it is often used as a

measure of cunent cost.

$eiia!il: ::i:l

penec :: i ,

huri l:,- -' : *' .:

The eti;:'COpe r*:-:- : :

treatn;:.. .:financ'- :: -. ..

staterne:-'i : "

Bcth :-r:::. - r'-

COnSeI"':- :reporie:::-.*'

If boi:- : -:PanYBli---:$700,0':d. ,

we have r::.:

€xp!*naiii: :*

Let us er.:: :.to a numb.:: .

are not i1':., :

Chapter3 FinancialAnalYsis

growth rate in earnings may be little more than an "inflationary illusion'" Industries

most sensitive to inflation-induced profits are those with cyclicai products, such as

.umber, copper, rubber, and food products, and also those in which inventory is a sig-

nlficant percentage of sales and profits.

A leveling offofprices is not necessarily bad. Even though inflation-induced corpo-

:ate profits may be going down, investors may be more willing to place their funds in

hnancial assets such as stocks and bonds. The reason for the shift may be a belief that

jeclining inflationary plessures will no longer seriously impair the purchasing power

,:f rhe dollar. Lessening inflation means the required return that investors demand on

:rnancial assets will be going down, and with this lower demanded return, future earn-

ings or interest should receive a higher current valuation'

None of the above happens with a high degree of certainty. To the extent that inves-

iors question the permanence of disinflation (leveling off of price increases), they may

:rot act according to the script. That is, lower rates of inflation will not necessarily

lroduce high stock and bond prices unless reduced inflation is sustainable over a rea-

.-.nable period.

Whereas financial assets such as stocks and bonds have the potential (whether real-

.zed or not) to do well during disinflation, such is not the case for tangible (real)

lssets. Plecious metals, such as gold and silver, gems, and collectibles' that boomed in

:re highly inflationary environment ofthe late 1970s fell off sharply a decade later, as

;oftening prices caused less perceived need to hold real assets as a hedge against infla-

:ion. The shifting back and fo'rth by investors between financial and real assets may

rccur many times over a business cycle.

ir-:i:i:t'l!g* There is also the danger of **il*{i*n, actual declining prices (which hap-

:ened in Russia, Asia, and other foreign countries in 1998), in which everyone gets

iurt from bankruptcies and declining profits.

- he effect of changing prices is but one of a number of problems the analyst must

:Llpe with in evaiuating a company. Other issues, such as the reporting of revenue, the

'-:eatment of nonrecurring items, and the tax write-off policy, cause dilemmas for the

:nancial manager or analyst. The point may be illustrated by considering the income

,:atements for two hypothetical companies in the same industry as shown in Table 3-8'

3cth firms had identical operating performances for 2009-but Company A is very

: tnservative in reporting its results, while Company B has attempted to maximize its

:ported income.

if both companies had reported income of $280,000 in the prior yea-r of 2008, Com-

:any B would be thought to be showing substantial growth in 2009 with net income of

! =00,000, while company. A is reportin g a "flat" or no-growth year in 2009. However,

,. e have already established that the companies have equal operating performances.

!:. , e., )r.;' 1lr "ii

,er us examine how the inconsistencies in Table 3-8 could occur' Emphasis is given

.:, a number of key elements on the income statement. The items being discussed here

,:: not illegal but reflect flexibility in financial reporting.

69

c*

#t&*r K$*e$e*${s

wf S$***rt8** 8m

ffi*pw**d &s**srYs*

,i &t

70

Ti!&!* s*&

Part 2 Financial Analysis and Planning

$s{*s Company B reported $200,000 more in sales, although actual volume was thesame. This may be the result of different concepts of revenue iecognition.

For example, certain assets pay be sold on an installment basis over a long period.A conservative firm may defer recognition of the sales or revenue until each pay-ment is received, while other firms may attempt to recognize a fully effected sale atthe earliest possible date. Similarly, firms that lease assets may attempt to consider along-1e.to lease as the equivalent of a sale, while more conservative firms only recog-nize as revenue each lease payment as it comes due. Although the accounting profes-sion attempts to establish appropriate methods of financial reporting through generallyaccepted accounting principles, there is variation ofreporting among firms.

Ssx** c$ &s*ds $s** The conservative firm (Company A) may well be using f,iF'{i}accounting in an inflationary environment, thus charging the last-purchased, more expen-sive items against sales, while Company B uses S{F$ accounting*-charging off less

expensive inventory against sales. The $300,000 difference in cost ofgoods sold may alsobe expiained by varying treatment of research and development costs and other items.

[Htrao{dssEasy fii}tex$Ilo$se$ Nonrecurring gains or losses may occur from tJre saleof corporate fixed assets, lawsuits, or similar nonrecurring events. Some analysts arguethat such extraordinary events should be included in computing the current incomeof the firm, while others would leave them off in assessing operating performance.Unfortunately, there is inconsistency in the way nonrecurring losses are treated despiteattempts by the accounting profession to ensure uniformity. The conservative Firm Ahas written off its $100,000 extraordinary loss against normally reported income,while Firm B carries a subtraction against net income only after the 9700,000 amounthas been reported. Both had similar losses of $100,000, but Firm B's loss is shown netof tax impiications at $70,000.

GcbPuse

A!Co4

ilfer ti}e si

{ww}tfrm asreFticofip

is he*a*irottabankS{

iwith s€r*fnsrn

SE TE

hofngives

key peratn

' resentes ha l

2. €tiPulalirg fir

Poteatbl ftnaofconcern m

tributons to {

3. AdequacYolls the cor4*knefit of sttagement? Aoptbns beintrulY indepc{Board d l*nattivitles ol'l

Extraordinan. ,

1ou might thir}l. (

decade. In the ;-:frner points o: ::;:

Hel lncome

Fiim A has reP:::.

traction of erE:a'--:

gls of financiai re;

Frlbrmance ha*c ;

::;h item ill the i

.'ii:lirtii:ll:{iill:€iaritv ot fi ra.l::liliill:ieomPanY ter:::::ir:t:,::]:. :iri:i8g to col€r t.ilr::i::i,::r:t.r:li.itb, RateFtrrltlr,i:tttrit:,,Flb, RateFtrr,,lii'tl:rll:rrilli:ll{t:ispy Krer*l:,llll::i:,:ri:t,:: jng" is prsfic

' :,:,,]:::tltt:::,::aCccunting t. rri.::rr,:r,:..ChiS€S and €

Extraordinary gains and losses happen among large companies more often thanyou might think. General Motors has had "nonrecurring" losses four times in the lastdecade. In the current age of mergers, tender offers, and buyouts, understanding thefiner points of extraordinary gains and losses becomes even more important.

Fl*t lm*omrs

Firm A has reported net income of $280,000, while Firm B claims $700,000 before sub-traction ofextraordinary losses. The $420,000 difference is attributed to different meth-ods offinancial reporting, and it should be recognized as such by the analyst. No superiorperformance has actually taken place. The analyst must remain ever alert in examiningeach item in the financial statements, rather than accepting bottom-line figures.

r:.

:'

t:

7I

Pirt:Z,. ,, financiizl Analysis and Planiing

S$m$eerw natio'analysis allows the anai:ysl io Compare a cornpanyrs'perforrnance ta that of oth=

ers,in itS industry.: Ratios that iqiti4lly appear,good ol .bad may not retain ihat charac-

teristic when measured against industry peers6-l

There are four main groupings of ratios. Pr\ifitability ratios measure theiFrm's abil-

ity to earn an adequate return on sales. assets, and stockholders' equity. Thb*'sset utili-zationiali6stell,the'anabst how quickly;lhe firm is lurolng oyerlts accqunts {eceivable,

inventory; and,longe!,-t€rm urr"tr. Liquffitty pSpios nreaqpre ttre finn'i rability: to pay otT

shqrt lerm,obJlgations.qq,,thgy cgme. due, and$dtt utitizationratios,indicate lhe overall

debt position of ,ths finn in li$, of it5 asse! ba-se' aild -earnitlg porller. ,

The'Du P;ti'sy:gtem of anal;r,sis firgt breaks dewn retur,n'on assets,between the

profit,margirt and,4ssetllurngver',lherSeCond gtep then shows how this retum on assets

iS tranSlated,into:retUrn on €qulty through the amount of debt the firm has. Through-

out the analysis, the analyst can better understand how return on assets and return on

equity are derived.

Over the course of the business cycle, sales and profitability may expand and con-

tract, and ratio analysis for any one yeaf may not present an accurate picture of the

firm.'Therefore we,look:at ihe irend analysis of perforrrnance,over a period of years.

A number of factors may distort the numbers the accountants actually reporl. These

iirclude ihe effect:,of,in{lation ot disinflation, the timing of the recognition of sales as

ievenue, ttri, treatrnent of inventOry Wrile-offs-;11he presence of extraordinary gains and

losses; arrd so on T&e well,trained-financial analysl muSt be'alert to all of these factors.

6. Why is trend an

7. Inflation can h:'and therefore o:on the follo*ii;assumPtions ''-

.. a, Retum on :

b" lnventoq' :'

c. Fixed a:se:

d. Debt-ro-as'

8. What efieci ''i:'rePorted inc'lr:

9. WhY might c:.:

i0. ComPariscrs :

theY sell the s.:

List ef Yerffis

l. Bames APP1:.:

of $4,000,C'l::-

a. Whar is ::.

b. What i' ::c. What is :-

d. The cieb:-r

wouic :r:the ter:

2. The Giilian J

Pute the Ptci:

prolitahility *at!*$ 5J ,,

e$$el {rtilk$tiorl raiitw..- 57 'tiq*i*ity rntios 57 ' '

*ich.t utilissfi{!$ r{}tit'}s 57

!]u licwt syslen: of *li*lysis 59

tlend unallsis 63

infiati*sr 6'lreg:1*cerner*t**!sts 67

etrlsirrf3*{i*n 68

deflaslaar 69l,x,F* 70sxp{:} ?0

Si*sru*sicn&$asttclts Ifwe diVide users ofratios into short-terffi lenders, long-term lenders, and

stockholders, which ratios would each group be ,ftosf interested in, and for

whal reasonq? 17gi2S 'Explain how the Du Pont syEtem of analysis breaks down retum on assets. Also

explain how it breaks down return on stockholders'equity. (LO3)

If the accounts recgivable tur-nover ratio is decreasing, what will be happening to

the average collection pet',od? (LO2)lfrhat advantage does the fixed charge coverage ratio offer over simply using

times interest carned2 (LOT)

Is there any validity in rule-of-thumb ratios for all corporations, for example, a

currenr ra:io of2 to 1 ordebt to asssts of50 percent? (L02)

1,

3.

2.

5.

6. Why is trend analysis helpful,in,analyziwgratios? (LO4) ' ,,

7. Inflation can have significant effects on income statements and balance sheets,

and therefore on the calculation of ratios. Discuss the possible impact of inflationon the followingratios, and explainr the direction of the lmpait based on your

,'asSumptjons.(L05) r. :',.. , , ,,,a. Retum on investment

;. b, InventO.rytur.n0vefr , i. ri r,.. : .. .,,1... .. ,, ,,, ,', 1 , : ,1.. .

..,c., FiXed,:asgettg,fnoyef ., r..: tt. .,..., . . ...., . ..1,,..,. ... i. ... :. 6f . ps!1;to-assets ratio '. . .1 ,

:

8. What effect will disinflation following a highly inflationary period have on the

, , reported ineome of tle,fqm? (LOs) ,'' , t '

9" W-hy, m.ight disiaflation:p{ove to be:faYorable to finaneial assels? (/,O5)

10. Comparisons of income can be very dilficult for two .ornpuni". even though

ihey sellrthe sarne producls in eQua! volume.'Why? {LOZ)' ,

BarnesApbllanceshas sales sf $10,000,008, netincome,of $450,000;:total assets

of$4,000'000,andstockho1ders'equity.of$2,000,000.:..a. What is the profit margin?

b. What is the return on assets?

c. What is the return on equiry?

d The debt-to.as5et$ ratio is currenlly 50 percent. If it were 60 percent, what

would the return on eguity be?'to answer this question, use formula 3D in

the text.

The Giiliam Corp. has the,following balance sheet and income'statement. Com-pute the profitability, asset utilization, liquidity, and debt uiilization ratios.

GILLIAM CORPORATION'Balance Sheet

Decembei 31,200xAssets .. i

:

Current assels:

Cash...Marketable securities

Accounls receivable (net) . . .

lnventorv

Tolal current assets . . " .

lnvestments.

Net plant €ind.equipment. . . . . .. . ;. . .. .

Total assets.

Frac'&tsePrablry_ms *xr$Ss8srg5ox?s ,

Frofrmbility ratiosars:]

All n3 ralirrs

{ t-{.}; }

$ 70,000

40,000

250,000

200,000

$ 560,000

100,000440,000

$1,100,000

continued

Pan 2 Fiwancial A,na,lysis and Flanning

Liabilities eftd St*ekhole*er€' HquityCrjrcnt liebilitie$:

Aecoutltg payablP "

itots$ payfible.

Accrucci taxes . .

'tutal Eurrent liabililies

Long-term liabilities:

Tatal stockholtJers' equit).

Total liabilitiec anel stoekholders'equl?t' . . . "

:l:i,::!:;:::..\

1. &. &ofit rn*rgin : h'Tetincoa'i:e $45*"$ffi)

Sales 51&,*10$,**0

F{et iircorne $458"*0eb. Return on assets :Toiaiassets 54,0{}fi,0$S

13t,0*r1

1t0,c00

$0,+s1l

$ r$*,0s0

3fi0,00*

620,0cl]

$i$gge

, a r.

Eonds payable

Total llabilities .. $ 480,{}00

Slockha!ders' equiry-

Fr*ferred stonk, $100 pilr v&li,s 1 5t.000ecrnnre* s:ock, $5 par vafue 50,000

Capita: $]aid iii excess of par. . . 200,$S0

fteteifted €ariling.e. _j?q{qq

GltLtAffi eSPFOffisATlSFi

fnc6me Stat€nnemt

F(rr lhe Vear ilnr*ng ileceanbes 31 , 2[}$X

Sales {ancredit}.. .. . "

Less: Ccst ol goods sola. . .

Gross pr0f:t

Less: $eliing and adnnin;strative expenees " . .. - . .

Operatircg prafjt {€SlT} " , .

Less: Inte";-st experise .

€arnings b*tore laxes iE$T) . .

Less: Taxes

tarnings after iar,es (LAl) . .

.lneludes $40,00S in i-Aase pa!,m6nt$.

. $2,4A0,S00

tfqgf#q. e*6,ss0. 5SS,*rr0-

" *,$0,*Sfl

. 3$.*0s

2't *,*il075,0ilc

$ I35"3tli

: 4"5Vo

: 1 t |,<q^

{:. Return s$ eqrrity

d. Retum on eqarity

2" Prefitairiiity rsti*s

i. R'cfit*argin :

{n - *ebtlAsse:si il "

Net ini:omr , ;:.., i1 ';- t,.1,:.4

Slockholders'cq,:'ly' -',r,i -',i

Retui:n *n assets {i.ni,estfil*ri) 1 1.?5%

11 1qq..- 14" t )'/C

.4

lJ*t:1"rry _ S:li.ndi : 5./: iii.$aies 2.4.1{1,0il0

lr, !

2. Refirm on assets :

3. Return an equity :

Asset utilization natios

Net income

4. Receivables tumover :

5. Average coliection period :

7.

Total assets i,100,000

Net income 5135,000 * .jt 1-n:-:=-- --:* - - -t'tt I

Stockholders'equity 620.000

Chapter -4 Financitsi Antiirsis

- $135'ooo : t2.Zla/a

Sales {credits) $2,400,000 : v"oxAccountsreceivable 250,ii00

Aecounts reeeivatrlo

6.Sales

Inventorv lumover' Inventory

SaiesFixeci asset iurnover

Fixed assets

Toral asset tumover : * s49u

Tolal assets

tiquidity ratios

9. Current ratio :

10. Quick ratio :

Current assets

Curuent liab!lities

560,000

280.000

Avg. daily credit sales

$2,4_o0r_otx) _200,CI00

_ $?:400,0CI9

440,000

* $2,4$0,00u1,100,0*0

$2s0"00{i : -) i.) ialS6,667

ttx

: 5.45x

- i la-

280" 000

Curreni assets * lnveniory _ $i9-O,Sqg_ jzuqqCurent liabilities

360,000 _ 1 4n_.- I.La^

280,000.

Detlt utilization ratios

1r. Debtrororaiassets : ffi : fffiffi : 43 64vo

Iy'ote: Income trefore interest aild taxe$ equals cperating pn:f?t, $240,11S0.

Times inrcresr earned -- ?19.goq : R*30,00CI

irrcome before fixed charges a-nd taxes13. Fixedehargecoverags : - Fixed;#---

lncome before fixed che,rges a.nd taxes : {J}perating pro{it plus Lrase payrnentr*

$240,000 + $40,s00 : $280,s0CI

Fixed charger = Lease paymenis + trnteffst

Income befone in{erest an<{ ta,xes12. Times interest earned :

Interest

$40,000 + $3CI,0ii0 : $70,000

Fixed charge colJe.age =$280,000 :4x?0,000

{Lease paymen;s ue ir a foiltnote on ihe iacoffr stalemer!