Citibabank Financial Statement Analysis

Financial Statement
Analysis
April 1995
Financial Statement Analysis
Warning
This workbook is the product of, and
copyrighted by, Citibank North America, Inc.
It is solely for the internal use of Citibank,
North America, Inc. and may not be used for
any other purpose. It is unlawful to reproduce
the contents of these materials, in whole or in
part, by any method, printed, electronic, or
otherwise; or to disseminate or sell the same
without the prior written consent of the
Training and Development Centers for Latin
America, Asia/Pacific and CEEMEA.
Please sign your name in the space below.
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Table of Contents
TABLE OF CONTENTS
Introduction
Course Overview ......................................................................................... vii
Course Objectives ...................................................................................... viii
The Workbook...............................................................................................ix
Unit 1: Accounting Issues in Financial Analysis

Introduction..................................................................................................1-1
Unit Objectives ............................................................................................1-1
Branches of Accounting..............................................................................1-2
Managerial Accounting ....................................................................1-2
Tax Accounting................................................................................1-2
Financial Accounting .......................................................................1-3
Generally Accepted Accounting Principles ........................1-3
Effects of Inflation................................................................1-4
Financial Accounting Basics...............................................1-5
Accounting Exercise .......................................................................1-6
Getting Behind the Numbers ....................................................................1-9
Contextual Factors..........................................................................1-9
Macroeconomic Effects......................................................1-9
Sector Accounting Norms ................................................1-10
Consolidated Numbers .....................................................1-10
Seasonality........................................................................1-11
Asset / Liability Valuation...............................................................1-12
Intangible Assets ...........................................................................1-13
Contingent Liabilities .....................................................................1-15
Summary...................................................................................................1-16
Progress Check 1 .....................................................................................1-19
Adjusting for Inflation .....................................................................1-25
Effects of Inflation on the Balance Sheet..........................1-25
Effects of Inflation on the Income Statement....................1-26
Inflationary Accounting......................................................1-27
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Unit 1: Accounting Issues in Financial Analysis (Continued)

Constant Currency Accounting ........................................1-28
Comprehensive Monetary Correction (MC).....................1-29
Additional Adjustments for Inflation...................................1-31
Comparative Financial Statements ..................................1-32
The Brazilian Experience..................................................1-32
Financial Analysis Spreadsheets ..............................................................1-33
Summary.......................................................................................1-35
Progress Check 1.2 ..................................................................................1-37
Unit 2: Basic Concepts of Financial Analysis

Introduction..................................................................................................2-1
Unit Objectives ............................................................................................2-1
Liquidity........................................................................................................2-2
Degree of Liquidity...........................................................................2-2
Importance of Liquidity ....................................................................2-2
Increasing Liquidity..........................................................................2-3
Liquidity and Balance Sheet Structure............................................2-3
Types of Capital ..........................................................................................2-3
Working Capital...............................................................................2-3
Permanent Capital ..........................................................................2-6
Third Party and Own Capital...........................................................2-7
Third Party Capital ..............................................................2-8
Own Capital .........................................................................2-8
Difference Between Liability and Net Worth Financing...................2-9
Summary...................................................................................................2-10
Progress Check 2.1 ..................................................................................2-13
Sources and Uses of Funds .....................................................................2-27
Sources and Uses in the Balance Sheet......................................2-27
Operating / Non-Operating............................................................2-29
Operating Sources and Uses ...........................................2-29
Non-Operating Sources and Uses ...................................2-30
Sources and Uses in the Income Statement................................2-30
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Unit 2: Basic Concepts of Financial Analysis (Continued)

Funds Generation Statement........................................................2-31
Summary of Sources and Uses ...................................................2-33
Funds Flow Analysis .....................................................................2-33
Summary...................................................................................................2-34
Progress Check 2.2 ..................................................................................2-35
Unit 3: Financial Statement Analysis

Introduction..................................................................................................3-1
Unit Objectives ............................................................................................3-1
Financial Statement Limitations ..................................................................3-2
Business Risk Assessment........................................................................3-3
Economic Environment...................................................................3-3
Market Conditions............................................................................3-4
Type of Business ............................................................................3-4
Management....................................................................................3-5
Progress Check 3.1 ....................................................................................3-7
Analysis Techniques ...................................................................................3-9
Vertical Analysis ........................................................................................3-10
Purpose.........................................................................................3-10
Balance Sheet...............................................................................3-10
Income Statement.........................................................................3-12
Summary.......................................................................................3-13
Progress Check 3.2 ..................................................................................3-15
Horizontal Analysis ....................................................................................3-25
Purpose.........................................................................................3-25
Technique......................................................................................3-26
Sales Growth.................................................................................3-27
Analyzing Net Sales Growth..........................................................3-27
Progress Check 3.3 ..................................................................................3-29
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Unit 4: Financial Ratios Liquidity

Introduction..................................................................................................4-1
Unit Objectives ............................................................................................4-1
Financial Ratios...........................................................................................4-2
Types of Financial Ratios................................................................4-2
Liquidity Ratios ............................................................................................4-3
Current Ratio...................................................................................4-3
Acid Test .........................................................................................4-6
Other Liquidity Indicators.................................................................4-8
Progress Check 4.1 ....................................................................................4-9
How Liquidity Ratios Change ....................................................................4-17
Progress Check 4.2 ..................................................................................4-21
Unit 5: Financial Ratios Leverage

Introduction..................................................................................................5-1
Unit Objectives ............................................................................................5-1
Total Indebtedness (Leverage) ...................................................................5-2
Calculation.......................................................................................5-2
Leverage Analysis ...........................................................................5-3
Incidence of Fixed Assets ..................................................5-3
Effect of Seasonality ...........................................................5-4
Financial Leverage..............................................................5-5
Tangible Net Worth .............................................................5-7
Revaluation Surplus ............................................................5-8
Other Adjustments ..............................................................5-9
Consolidations and Minority Interest ................................5-10
Current and Long-Term Indebtedness Ratios ..........................................5-12
Fixed Assets Covered by Own Resources ..............................................5-13
Coverage Ratios .......................................................................................5-14
Funds From Operations Interest Coverage .............................5-14
Funds From Operations Long-Term Debt Coverage ..............5-15
Debt Service Ratio ........................................................................5-15
Summary.......................................................................................5-16
Progress Check 5 .....................................................................................5-19
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Unit 6: Financial Ratios Turnover

Introduction..................................................................................................6-1
Unit Objectives ............................................................................................6-2
Receivables Turnover / Days Receivable...................................................6-2
Receivables Turnover Ratio............................................................6-2
Days Receivable .............................................................................6-4
Summary.........................................................................................6-6
Progress Check 6.1 ........................................................................6-9
Inventory Turnover or Days Inventory .......................................................6-13
Inventory Turnover.........................................................................6-13
Days Inventory...............................................................................6-14
Summary.......................................................................................6-17
Progress Check 6.2 ..................................................................................6-19
Payables Turnover or Days Payable ........................................................6-23
Payables Turnover ........................................................................6-23
Days Payable ................................................................................6-24
Common Variation ............................................................6-25
Seasonality........................................................................6-26
Interpreting the Number ....................................................6-27
Summary.......................................................................................6-28
Progress Check 6.3 ..................................................................................6-29
Unit 7: Financial Ratios Profitability

Introduction..................................................................................................7-1
Unit Objectives ............................................................................................7-1
Profitability Ratios........................................................................................7-2
Return on Sales ..............................................................................7-2
Return on Assets ............................................................................7-3
Return on Equity (Return on Capital)..............................................7-4
Progress Check 7.1 ....................................................................................7-7
Integrated Analysis ....................................................................................7-11
Return on Assets ..........................................................................7-11
Return on Equity............................................................................7-12
Application of DuPont Formulas ...................................................7-12
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Unit 7: Financial Ratios Profitability (Continued)

Summary.......................................................................................7-15
Progress Check 7.2 ..................................................................................7-17
Summary of Financial Ratios....................................................................7-21
Unit 8: Applied Financial Analysis Case Studies

Introduction..................................................................................................8-1
Unit Objectives ............................................................................................8-1
The Bank Spreadsheet Financial Analysis Model.......................................8-2
Case Study: Mindy Garment Factory.........................................................8-9
Exercise 8.1 ..................................................................................8-15
Case Study: The Tower Stores ...............................................................8-39
Exercise 8.2 ..................................................................................8-51
Appendices
Appendix A...................................................................................................A-1
Appendix B ..................................................................................................B-1
Appendix C Glossary..............................................................................C-1
Index
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Introduction
INTRODUCTION
COURSE OVERVIEW
Welcome!
You are about to learn the basic financial concepts and techniques used to interpret and
analyze the financial and economic position of a company. These techniques form the
foundation of financial statement analysis. After completing the course, you should be able
to apply financial analysis techniques to perform an in-depth quantitative analysis of a
companys financial situation.
This course is useful for relationship manager trainees and others working in the credit area
who wish to improve their credit analysis capabilities in order to support individual credit
decisions.
The opening unit of this workbook deals with accounting issues as they pertain to financial
statement analysis. The workbook does not teach accounting. If the reader has very little
exposure to accounting, it may be more productive to first upgrade accounting skills
through an accounting textbook or self-instruction workbook (e.g. Robert N. Anthonys
Essentials of Accounting). If you do not have the Anthony self-instruction book available,
contact your Training Coordinator or the PDC.
A brief section on financial statement structure is included in Appendix A, along with some
short exercises, to provide support for readers with an incomplete knowledge of
accounting. The material may be helpful to refresh some concepts, but it is insuffient to
teach the subject.
The course is divided into eight units:
Unit 1 Accounting Issues In Financial Analysyis
Unit 2 Basic Concepts of Financial Analysis
Unit 3 Financial Statement Analysis
Unit 4 Financial Ratios Liquidity
Unit Five Financial Ratios Leverage
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viii
INTRODUCTION
Unit Six Financial Ratios Turnover

Unit Seven Financial Ratios Profitability
Unit Eight Applied Financial Analysis Case Studies
We have designed this course in workbook form which follows a logical sequence
using a self-instructional format. You should work through the units at your own pace in the
order they're presented, because each contains information that builds from previous units.
For your convenience, we have included a glossary of terms at the back of the workbook.
COURSE OBJECTIVES
When you complete this workbook, you will be able to:

+
Identify accounting issues that impact the financial analysis process
Recognize some basic concepts that help an analyst form a more complete
picture of a companys financial health
Apply techniques that are used to evaluate a companys financial condition
Calculate financial ratios to understand the relationships among various

financial statement accounts
Apply the financial anlysis procedures using a bank spreadsheet model
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INTRODUCTION
ix
THE WORKBOOK
This workbook is designed to give you complete control over your own learning. The
material is divided into workable sections, each containing everything you need to master
the content. You can move through the workbook at your own pace and go back to review
ideas that you didnt completely understand the first time. Each unit contains:
Objectives
which point out important elements in the

lesson that you are expected to learn.
Text
which is the "heart" of the workbook. These

sections explain the content in detail.
Key Terms
which also appear in the Glossary. They

appear in bold face the first time they appear
in the text.
Instructional
Mapping
terms or phrases in the left margin which

highlight significant points in the lesson.
Progress Checks
which do exactly what they say check your

progress. Appropriate questions are
presented at the end of each unit, or within
the unit in some cases. You will not be graded
on these by anyone else; they are to help you
evaluate your progress. Each set of questions
is followed by an Answer Key. If you have an
incorrect answer, we encourage you to review
the corresponding text and find out why you
made an error.
In addition to these unit elements, the workbook includes:
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Appendix A
Unit One Accounting Exercise Answer Key
Appendix B
Financial Statement Structure
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INTRODUCTION
Appendix C
Glossary
Definitions of all key terms used in

the workbook.
Index
Guide for locating glossary items in

the workbook.
Since this is a self-instructional course, your progress will not be supervised. We expect
you to complete the course to the best of your ability and at your own speed. Now that you
know what to expect, please begin with Unit One. Good luck!
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Unit 1
UNIT 1: ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
INTRODUCTION
A business is a collection of economic and human resources devoted to a particular purpose

or goal. This business may be in the commercial, industrial, agricultural, service, or other
sectors. Whatever its purpose, every business organization must measure its efforts in
monetary terms for both legal and business reasons.
Accounting is the systematic recording and presenting of daily transactions that
occur in any business organization. Bookkeeping the process of recording daily
transactions through the use of debits and credits, journals, and ledgers is a part of
accounting. But accounting is much broader than compiling these financial details. Together
with financial analysis, accounting encompasses an understanding of what
is behind the numbers and an interpretation of them to get an even and comprehensive
picture of the financial position of a company.
UNIT OBJECTIVES
When you complete this unit, you will be able to:

n
Differentiate between managerial accounting, tax accounting, and

financial accounting
Recognize the use of rules and guidelines for reporting financial results
Recognize five issues to consider in the financial analysis process
Calculate monetary corrections of a company in a high inflationary

economy and show the adjustments as a gain or loss
Explain the impact of inflation on determining a company's financial

position and the results of its operations
Recognize some features of an electronic spreadsheet model for

financial analysis
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1-2
ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
BRANCHES OF ACCOUNTING
In a broad sense, accounting can be separated into three major

branches:
1. Managerial accounting
2. Tax accounting
3. Financial accounting
Managerial Accounting
Financial
information for
internal use
only
Managerial accounting provides information to management, for

internal use only, based on guidelines and rules established by
management to accommodate the companys specific needs. For
example, it may account for internal redistributions of revenue or cost
allocations between business units to enable more accurate
measurement of a units profits.
You can learn more about Citicorp / Citibanks managerial accounting
in the Citicorp MIS self-instructional workbook, which
is written for the Financial Control professional.
Tax Accounting
Information
to facilitate
assessment of
tax implications
Tax accounting is governed by legislation in the applicable legal

jurisdiction. Tax implications may have a profound effect on how
companies organize themselves and do business. Counsel in the tax
area may be provided to management by lawyers or accountants skilled
in these matters, or by internal experts within a company.
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1-3
Financial Accounting
Financial
information
reported outside
the company
Financial accounting provides information on the results of a

companys operations to people outside of management, such
as creditors, investors, stockholders, and government agencies.
Citibankers or other credit analysts use this information to assess
the historical cash generation and financial position of a company.
From this information base, the analyst can build projected numbers,
based on historical trends and prudent economic and business
assumptions, to measure the business risk of dealing with this actual
or potential client. It is this type of accounting that concerns us in
this workbook.
Generally Accepted Accounting Principles
Since financial accounting results are used by people outside of the

business to assess the financial position of a company, it is necessary
for these results to be reported according to a set of standards. The
rules and guidelines for reporting financial results are known as
Generally Accepted Accounting Principles ( GAAP). In the United
States, these principles are defined by the Financial Accounting
Standards Board ( FASB). Each country has its own equivalent of
the FASB composed of professional accountants who define the
accounting principles to be followed in presenting financial accounts
within their jurisdiction.
Example
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While many of the principles are universal, others may vary from
country to country or region to region. The impact of area-specific
principles can be demonstrated with an example. Only one European
firm (Daimler Benz) is now listed on the New York Stock Exchange
because it is the only European company that has been willing to
express its financial statements in accordance with the requirements
of the FASB in the United States. Currently, there may be fundamental
differences in accounting principles applied from country to country,
but the trend internationally is to unify standards over time.
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1-4
Effects of Inflation
The major difference between Latin American accounting principles

and GAAP applied in the United States is a response to the high
inflation experienced in many Latin countries. This situation has
created a need in several Latin American countries to develop an
indexing scheme in order to provide a meaningful framework for
financial accounting and for the analysis of financial statements.
While the level of inflation recently has been reduced in most Latin
countries, many of these countries (Brazil, Chile, Peru, Mexico, etc.)
still maintain a monetary correction scheme that is at variance with
the GAAP of the United States. This scheme may be in place for some
time due to the fact that inflation levels, which are considerably lower
than in the past, are still high by US standards. If lower inflation
becomes a permanent feature, the need for monetary correction will be
eliminated and use of this methodology may be phased out in many of
these Latin countries (as occurred in Argentina in late 1995). As this
occurs in other countries as well, unification of standards with the US
may become possible in the future.
There are other differences between GAAP in the US and in Latin
America; for example, intangible assets such as deferred expenses and
goodwill (discussed on page 1-131-15). The financial analyst must
understand these differences since it may be necessary to adjust the
financial numbers presented by a company for analysis purposes.
Financial Accounting Basics
To interpret financial statements and make the necessary adjustments

to accommodate differences in accounting principles,
a financial analyst must understand the basics of accounting. This
involves a thorough understanding of the composition of the balance
sheet and income statement.
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1-5
An analyst must also understand the basics of balance sheet and

income statement accounts and how each account fits within the
overall structure of the respective financial statement. Without a
basic understanding of accounting, it may be difficult for you to
understand the material in the remainder of this workbook. To check
your accounting knowledge, please complete the brief exercise that
begins on the next page.
When you have completed the exercise, check your answers with
the answer key in Appendix A. If your level of understanding is
insufficient to complete the exercise with substantially correct
numbers, we recommend upgrading your accounting knowledge,
perhaps through an accounting textbook or self-instruction workbook
(e.g. Robert N. Anthonys Essentials of Accounting) or refreshing
your skills by working through Appendix B Financial Statement
Structure.
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1-6
Accounting Exercise
PART 1: Use the indivi dual accounts below to create a balance sheet and an income statement.
Fill in the blanks on the next two pages and calculate the subtotals
and totals.
Due banks short term

Inventory
Other current liabilities
Capital stock
Accounts payable
Prior year ending retained earnings
Current portion of long-term debt
Sales
Cash and banks
Income tax expense
Long-term debt (not including current portion)
Selling, general, administrative expenses
Prepaid expenses
Accounts receivable
Taxes payable
Other expense
Depreciation
Net fixed assets
Interest expense
Other current assets
Accruals
Marketable securities
Cost of goods sold
Legal reserve
Long-term investments
Obligation for employee pensions
Dividends paid
License rights
-?600
100
800
250
350
50
3,000
50
100
200
300
100
500
50
50
100
1,000
150
100
150
150
2,000
100
300
100
50
200
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1-7
BALANCE SHEET
Assets
__________________________
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Liabilities
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
__
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1-8
INCOME STATEMENT
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
____________________________
____
Net Income
_______
PART 2: What are the short-term bank debt, ending retained earnings, balance sheet totals,
and income statement subtotals?
Short-term bank debt.....................................................________

Ending retained earnings .................................................________
Total current assets ........................................................________
Total non-current assets .................................................________
Total assets....................................................................________
Total current liabilities.....................................................________
Total non-current liabilities..............................................________
Total liabilities ................................................................________
Total net worth (stockholders equity).............................________
Gross margin..................................................................________
Operating margin............................................................________
Profit before taxes..........................................................________
Net income ....................................................................________
Check your answers with the Answer Key in Appendix A.
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1-9
GETTING BEHIND THE NUMBERS

Special
accounting
issues to
consider
The objective of a good financial analyst should be to get behind the

numbers to achieve greater depth and quality in risk and needs
assessment. There are many special accounting issues and areas that
should be considered, including:
n
Contextual factors
Asset / liability valuation
Intangible assets
Contingent liabilities
Adjustments for inflation
Contextual Factors
It is necessary to understand the business environment in which
a company operates to permit judging the sufficiency or
appropriateness of the numbers and the ratios calculated from
them. Contextual factors that impact financial statements include
macroeconomic effects, sector accounting norms, consolidated
numbers, and seasonality.
Macroeconomic Effects
Changes in
a countrys
economy
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Inflation and economic growth are examples of macroeconomic

factors that may affect financial numbers and which must be
considered when interpreting the sufficiency of the numbers.
Indexation schemes attempt to deal with inflation, but even where
there is no formal indexation, as in the US, the effects of inflation
must be considered when interpreting numbers and growth rates.
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1-10
Sector Accounting Norms

Shaped by
economic
activity
Different economic sectors have different norms for accounting

numbers and ratios. These norms are the result of the economic
activity of the companies within the sector, and the assets they require
to pursue these activities.
Examples
For example, heavy industrial companies normally require a large

amount of fixed assets for their production, and these fixed assets
require substantial amounts of capital to sustain them on the balance
sheet. On the other hand, a trading company needs little more than
office equipment to run its operations, probably renting its office
space. This means that it needs relatively lower levels of capital and
can assume greater debt relative to capital.
These differences in fixed asset needs can have major repercussions
in the asset structure and distribution within the balance sheet, which
can affect margins and economic performance (Refer to Unit Two).
The level of capital that is appropriate for one company may be
inappropriate for another and, to enable a thorough analysis, the
analyst should understand the difference.
Consolidated Numbers
Combined
financial
statements
The analysts job may become more complex when analyzing

consolidated financial numbers for a group of companies.
Consolidated numbers represent the combined financial statements
of a group of interrelated companies that report as if they are one
company.
From the analysts point of view, it is important to get this overview
since the funds generation of the group of companies may be involved
in repayment, or since funds may be more easily diverted
to related companies when dealing with groups.
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1-11
At the same time, it may be more difficult to understand the numbers

since many other factors may have an impact. If the group is vertically
integrated, then the numbers often will include producers and
commercial companies. The final result, in terms of a consolidated
financial statement profile, will be to average everything out so
that ratios are not typical of any specific type of company. In such
situations, it is more difficult to assess propriety
of numbers, performance, and risk.
With the possibility of many companies being involved in group funds
generation, it is more difficult to understand the various critical risk
factors and the basis for the numbers of each individual company. The
analysis then requires much greater depth to be effective in assessing
risk.
Seasonality
Seasonal
business activity
Many companies have to deal with seasonal production or sales. For

some companies, the seasonality of their activity is obvious, as in the
agricultural or agroindustrial sectors; for other companies, the effect
may be less pronounced. For still others, seasonality may not be a
factor.
The extent to which a companys operations are seasonal can have
a major impact on the analysis of its financial statements. Since the
balance sheet is a snapshot of the company at a certain date, some
accounts (receivables, inventory, short-term bank debt, payables) may
be at increased, reduced, or average levels. It is very important for the
analyst to recognize the seasonality of a companys business since
several ratios (particularly turnover ratios) may be impacted to the
point where they may lead to false conclusions. We will discuss
examples of this later.
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1-12
Asset / Liability Valuation

Application of
appropriate
GAAP
The applicable GAAP should govern the valuation methodology used

for preparing the numbers and, theoretically, if the correct principle
is followed, the numbers should be trustworthy. Sometimes, however,
the principles are not applied evenly and the analyst must assess the
value of the asset or liability as listed on the balance sheet.
Examples
One example may be to question whether receivables have been

properly recorded to reflect uncollectables, particularly in
economically difficult times. When dealing with vulnerable products
such as high tech products that often have short life cycles, check to
see if inventory obsolescence has been factored in. Another example
is inventories of commodities (coffee, fruit concentrate, cotton,
minerals, etc.) which should be valued at the lower of cost or market
on a continual basis but, perhaps, may not be adjusted properly.
While the accounting cost principle states that all items will be
recorded at original cost, the accounting profession also recognizes
the need to reflect an updated value where accumulated inflation may
cause historical cost to be misleading. For example, in most (if not
all) Latin American countries, it would be inappropriate to value fixed
plant and equipment that was acquired in the mid 1970s, with
a useful life of 40 years, at present depreciated cost valuation. This
would be misleading when the analyst considers that accumulated
inflation during these intervening 20 years may exceed 20,000% in
some countries.
Revaluation in
Latin America
Revaluation of fixed assets within specific guidelines is generally

permitted in Latin America. The guidelines stipulate the minimal
amounts of accumulated increase in price indices that can trigger
the change, and the valuation methodologies that may be used to
update these fixed assets. Tax treatment for revaluation of assets
may vary from country to country but, where it is taxed, it obviously is
a disincentive to revalue.
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In a revaluation, the corresponding entry to the net increase in fixed

assets is an equal increase in the net worth account revaluation
surplus. Therefore, the direct result of a revaluation is to increase
net worth. If an analyst reviews the net worth accounts of most
companies listed on stock exchanges in Latin America, well over half
the amounts may be the result of revaluation surplus. This is a legacy
of the high inflation environment of the 1980s. Nevertheless, fixed
asset revaluations should be questioned for propriety since the
methodology used may impact the numbers, affecting the total net
worth and the leverage ratios.
On the liability side, foreign currency debt must be listed on the
balance sheet at the equivalent in local currency, as of the balance
sheet date. In some cases, this account may not be updated as required,
or a subsequent devaluation may render the numbers
out of sync with current reality.
Intangible Assets
Adjust for
unrealizable
assets
According to standard financial analysis theory, for purposes of

computing an adjusted leverage position, intangible assets should
be subtracted from net worth to compute tangible net worth. This
adjustment recognizes that very often these assets cannot be realized
(unless the company itself is sold) and, therefore, do not provide
coverage of assets to pay out liabilities.
Example:
Deferred
expenses
This theory usually is applicable for intangibles such as deferred

expenses and goodwill. Deferred expenses, such as start up costs
that are capitalized instead of written off against earnings, is another
area where there is a general variance between Latin American and US
GAAPs.
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In Latin America, start-up costs may be capitalized and amortized over

several years. The theory is that start-up costs benefit the company
over time and not just in the year incurred. The effect of this is to
significantly reduce a loss (or overbook a profit), thereby overbooking
net worth and improving the debt / equity position of the company. It
also results in a greater variance between the cash position of the
company and the reported net income figure.
US GAAP requires writing off start-up costs against earnings in the
period in which they are incurred. The result is reduced earnings (or a
loss) which immediately impacts net worth, reflecting a stricter view
of the companys capital account position. This position is consistent
with netting intangibles against net worth for calculating tangible net
worth, and is appropriate for this type of intangible.
Example:
Licenses
Having said this, however, we must understand the logic and apply
it to other intangibles. Consider patents, copyrights, and licensing
agreements. What is a brewery or soft drink bottling companys most
valuable asset when it produces someone elses branded product?
What is the most valuable asset for a distiller, a perfume / cosmetics
producer, or a cigarette manufacturer? Answer: The license to
produce the branded product.
Yet, a license is an intangible. So, why should we automatically net
this most valuable asset against net worth to calculate tangible net
worth? This would not be logical because, even though the asset is an
intangible, it has a market value; in many instances, it could be sold for
greater than its listed value on the balance sheet.
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By the way, lets remember a small but important issue here. A

brewery with its own brand does not necessarily have this reported on
the balance sheet as an intangible asset. US GAAP, as in many other
countries, requires that unless the brand or company has been sold
in an open market, the value of the brand name does not appear on
the balance sheet. A sale on the open market involves a specific cost
to the buyer and, without it, it is too subjective to value the item. Some
accountants feel that some formula should be developed for this type
of valuation, but GAAP currently stipulates that the item does not
appear on the balance sheet at an arbitrary market value.
Example:
Goodwill
Another example is goodwill that is reflected on the balance sheets of

recently privatized companies. In these cases, the capital market in the
respective country has quite recently set the value of the asset, proving
its worth on an open market.
We can see the need for discriminating between categories of
intangibles before making automatic adjustments on the balance sheet.
This discrimination will enable a higher quality of analysis.
Contingent Liabilities
Contingent liabilities, when added to direct liabilities, sometimes can
have a major impact on how an analyst judges the overall financial
position of a company. The analyst should, therefore, consider the
possible impact of contingencies particularly when judging the
capital sufficiency of a company.
The most common contingent liabilities probably are corporate
guarantees and open foreign currency positions. Another off balance
sheet liability lease obligations should also be considered.
It is important for analysts to give appropriate consideration to all
of these items in order to permit an understanding of the companys
overall financial position and business risk.
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There may be a significant difference in the perception of the balance

sheet when contingent liabilities are included and when they are not
included, particularly in the case of leased assets and their
corresponding payment obligations. There may be major swings in
asset turnover and capital adequacy ratios. Airlines and transport
companies may be especially noteworthy examples, since these types
of companies often lease major amounts of fixed assets.
This is another area where US and Latin American GAAP may differ.
US GAAP require capitalization on the balance sheet of all items
acquired as capital leases, along with the corresponding liabilities,
valued at the net present value of the lease. Operating leases are
charged to expenses. Some countries in Latin America require similar
treatment, but others may not.
The analyst should clearly understand how these rules apply within
his/her jurisdiction. Some questions to ask include: What are the
specific rules? What is a capital lease and what is an operating lease?
Where there are ambiguities or an alternative accounting treatments,
these ambiguities or alternatives should be clearly understood.
SUMMARY
Accounting, the systematic tracking and reporting of daily financial

activity in a company, may be separated into three major branches:
1. Managerial accounting for internal use
2. Tax accounting for calculating tax liabilities
3. Financial accounting for presenting a financial accounting
of a company to outside parties
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Financial analysis is an effort to interpret the numbers reported

in financial statements. Several issues must be considered when
analyzing the numbers, including the general business environment in a
country, methodology applied to the valuation of assets, reporting of
intangible assets and contingent liabilities, and adjusting for inflation.
In this section, we discussed four of these accounting issues. Please
complete Progress Check 1.1 to check your understanding of these
concepts and then continue on to the section on Adjusting for
Inflation.
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PROGRESS CHECK 1.1
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 1: A company is producing financial statements for publication in its annual

report. This is an example of:
____ a) managerial accounting.
____ b) financial accounting.
____ c) tax accounting.
Question 2: A company wants to know how much it will have to pay the local regulatory
agency if it implements a new product that is profitable. This is an example
of:
____ a) managerial accounting.
____ b) financial accounting
____ c) tax accounting.
Question 3: A company has restructured its accounting procedures to accommodate a
need for business units to know individually the amount of their monthly
expenses. This is an example of:
____ a) financial accounting.
____ b) tax accounting.
____ c) managerial accounting.
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ANSWER KEY
Question 1: A company is producing financial statements for publication in its annual

report. This is an example of:
b) financial accounting.
Question 2: A company wants to know how much it will have to pay the local regulatory
agency if it implements a new product that is profitable. This is an example
of:
c) tax accounting.
Question 3: A company has restructured its accounting procedures to accommodate a

need for business units to know individually the amount of their monthly
expenses. This is an example of:
c) managerial accounting.
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PROGRESS CHECK 1.1

(Continued)
Question 4: The responsibility of the FASB or its equivalent in other countries is to:
____ a) unify global standards for presenting financial accounts.
____ b) define the principles to follow for financial accounting within its
jurisdiction.
____ c) develop an indexing scheme for financial reporting.
____ d) monitor the compliance of non- US companies with GAAP in order
to qualify for listing on the New York Stock Exchange.
Question 5: Identify three business factors that may affect the interpretation of a
companys financial statements.
____ a) Low inflation
____ b) Internal cost allocations between related companies
____ c) High level of leased fixed assets
____ d) Increased sales in the fourth quarter for a Christmas tree ornament
company
____ e) Internal capital use charges
Question 6: When Generally Accepted Accounting Principles are not evenly applied:
____ a) the value of fixed assets must be adjusted to account for inflation.
____ b) the taxes applied to the revaluation of assets must be considered.
____ c) there is no impact on the balance sheet.
____ d) the resulting numbers may not fairly reflect the financial position
of the company.
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ANSWER KEY
Question 4: The responsibility of the FASB or its equivalent in other countries is to:
b) define the principles to follow for financial accounting within its
jurisdiction.
Question 5: Identify three business factors that may affect the interpretation of a
companys financial statements.
a) Low inflation
c) High level of leased fixed assets
d) Increased sales in the fourth quarter for a Christmas tree ornament
company
Question 6: When Generally Accepted Accounting Principles are not evenly applied:
d) the resulting numbers may not fairly reflect the financial position
of the company.
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PROGRESS CHECK 1.1

(Continued)
Question 7: Intangible assets such as brand names developed by a company are difficult
to value because:
____ a) they cannot be changed.
____ b) they cannot be sold.
____ c) their values may not have been tested on the open market.
____ d) they have no value.
Question 8: Identify two common contingent liabilities.

____ a) Open foreign currency position
____ b) Corporate guarantee
____ c) Purchase of large amounts of fixed assets
____ d) Monthly office rent
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ANSWER KEY
Question 7: Intangible assets are difficult to value because:

c) their values may not have been tested on the open market.
Question 8: Identify two common contingent liabilities.

a) Open foreign currency position
b) Corporate guarantee
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Adjusting for Inflation

Before the progress check, we discussed four accounting issues that
are of special concern to the financial analyst: contextual factors,
asset valuation, intangibles, and contingencies. The final area of
concern includes the issues associated with adjusting for inflation.
Example
Inflation is a general increase in prices or a general shrinkage in the

purchasing power of the currency. For example, in an inflationary
environment, if a liter of gas costs 100 Lcy today, it will take more
currency in the future to buy the same amount of gas.
In accounting, all transactions are measured in monetary terms.
Consequently, the accuracy of accounting depends on the stability
of the currency's purchasing power. After prolonged periods of
inflation, or periods of high inflation, figures reported in financial
statements are meaningless unless adjustments are made to reflect the
effects of inflation.
Effects of Inflation on the Balance Sheet
According to GAAP, accounts must be stated at historical cost.

However, in times of high inflation, figures reported in the balance
sheet may actually reflect historical value, present value, or even
future value. Let's see why this occurs.
Accounts stated
at historical
value
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Although all items are exposed to inflation, the impact can be low
or high depending on the turnover of the item. Inventories is one
example. If a company has a high turnover of inventories, the cost
reported in the balance sheet will be relatively close to current or
replacement cost. Conversely, if the turnover is low, considering that
historical cost is used to value inventories, the reported cost will be
lower than the current or replacement cost.
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It is easy to imagine that inflation has the greatest impact on

permanent assets and equity. For example, land purchased decades ago
is reflected in the balance sheet as its cost at the time of purchase.
Accounts stated
at future value
In countries where inflation has been high for a long time, a significant
distortion is created in the form of expected inflation. This occurs
when the price for a credit sale is significantly higher than the price
for a cash sale. In this situation, the accounts receivable in the
seller's books and the accounts payable in the buyer's books are
reported in future value terms.
Accounts stated
at present value
When balances in accounts are stated at present value, they are

expressed in terms of their purchasing power as of the date of the
financial statements. The best example of a present-value account
is Cash, which includes all funds immediately available to the
company.
Effects of Inflation on the Income Statement
Reflects a
period of growth
Inflation impacts the income statement in a different way. The income

statement reports the results accumulated over a period of time and,
therefore, even when operating volumes remain constant, income and
expense figures grow from year to year. Earnings per share also
become proportionally higher, unless the company issues additional
shares at inflated prices. In inflationary environments, companies
seem to grow all the time. Judging only from a series of consecutive
income statements, bankers would be very happy to grant credit to
many of them.
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Uneven
measurements
resulting from
seasonality
1-27
But, this is not the only problem. Since income statements compile
data from several months, the aggregate measurements are made with
quite different yardsticks. This is not so important when sales and
expenses are relatively even throughout the year, but seasonal flows
are quite common for many companies. Consequently, revenues of
companies with sales concentrated in the beginning
of the year are understated and revenues of companies with sales
concentrated in the end of the year are overstated. The same applies to
expenses.
Inflationary Accounting
Problems
All accountants agree that the effects of inflation must be measured,

but most also agree that existing methods are experimental, involve
too many assumptions and judgments, and results are only estimates.
Also, GAAP and income tax regulations vary from country to country.
In some cases, even inflation indices published by the government
agencies are not reliable.
Solutions
There are two ways of overcoming these problems:
Foreign
currency
accounting
Foreign currency accounting, often using the US dollar
Constant currency accounting
For several countries, the US dollar is more stable than local currency
and, therefore, many companies keep unofficial accounts in US
dollars. These accounts usually have no legal value, but they can help
the analyst make better judgments, even though inflation also affects
US dollars.
When analyzing a company that is a subsidiary of a foreign company,
the analyst should obtain financial statements sent to the head office.
These statements are prepared using a stable currency (e.g. US dollars)
which facilitates a better understanding of the company's financial
position. They are also more reliable, because local financial
statements are not always audited.
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Constant
currency
accounting
Constant currency accounting uses a form of strong currency, usually

hypothetical, as a unit of measurement. In practice, this means keeping
accounts in an indexed currency. This comprehensive procedure is
designed to produce comparable financial statements. In the next
section, we will see how this is accomplished.
Constant Currency Accounting
Before we discuss indexation, it is fundamental that we understand what

should be indexed and why which brings us to the concept of
monetary and non-monetary items under assets, liabilities, and equity.
Monetary items
The nominal value of monetary items, such as cash, accounts

receivable, accounts payable, and bank debt, remains constant over
time. Obviously, in an inflationary environment, the associated
purchasing power of these items decreases over time. Monetary assets
generate losses due to the reduction in purchasing power of cash or
future cash inflows, such as accounts receivable. Conversely,
monetary liabilities generate gains due to the reduction in purchasing
power of future cash outflows, such as accounts payable and bank debt.
Non-monetary
items
Non-monetary items maintain their actual, intrinsic value over time.

Examples of these items are fixed assets, long-term investments,
inventories, and equity. Since these items have been acquired some
time in the past, their historical cost is lower than their present value
in an inflationary environment.
Comprehensive Monetary Correction (MC)
Let's look at the basic mechanics of monetary correction of financial

statements.
Monetary items
reflected in
the Income
Statement
Since monetary items are already expressed at their present value, no

monetary correction should be calculated for the purpose of disclosure
in the balance sheet. On the other hand, since assets generate monetary
losses and liabilities generate monetary gains, these variances should be
calculated and reclassified on the income statement.
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Example
1-29
For example, let's examine the transactions for one specific month,
based on the following assumptions:
n
10% inflation for the period
All monetary items were exposed to inflation during the whole

month
The sale was effected on the first of the month
You can see this reflected in the adjusted financial statement in

Exhibit 1.1.
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Earnings
impact
adjustments
Balances
before MC
MC
Cash
Receivables
Inventories
Fixed Assets
100
200
180
430
10
20
18
43
(10)
(20)
100
200
198
473
Total
910
91
(30)
971
Payables
Capital
Retained Earnings
- Opening Balance
- Income of the period
360
150
36
15
(36)
360
165
210
190
21
19
231
215
Total
910
91
(30)
971
Income for the period

Sales
Cost of Sales
320
130
32
13
352
143
Net Profit
190
19
209
Account
Gain on Net Monetary Items

Net Income
l
190
l
19
6i
6
Balances
after MC
6
215
Exhibit 1.1: Financial statement adjusted for inflation
You can see that the company reports a gain on net monetary items of
6 Lcy, which is the net result of:
n
Loss on monetary assets:

Cash
(10)
(20)
Receivables
Gain on monetary liabilities

Payables
36
Net gain on monetary items
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Non-monetary
items
1-31
Since there are no monetary gains or losses from non-monetary items,

monetary correction of these items will not affect the income
statement. However, since they were acquired in the past, the asset or
equity balance for each of these items should be restated to current
price levels in the balance sheet.
Additional Adjustments for Inflation
Remunerated
monetary items
In countries where inflation has been constant for a long time, it is

difficult to find true monetary items. Most assets and liabilities are
protected from inflation with instruments and contracts that adjust
their values according to the official inflation indices. These are
remunerated monetary items.
Example
For instance, a company invests excess cash in a certificate of deposit

(CD) that pays interest at 12% p.a. and also pays the variance in the
official inflation indices. When making accruals, the amount recorded
as financial income is a combination of actual interest and monetary
correction. To really measure the effects of inflation in the financial
statements, the monetary correction paid on the CD should be
transferred from Financial Income to Gain on Monetary Assets.
Similarly, for a loan in foreign currency, the company has to pay the
interest, which is the actual financial expense, and also the exchange
variances. All exchange losses incurred on this loan should be
reclassified from Financial Expense to Losses on Monetary Items.
Discounting
receivables /
payables to
present value
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Since credit sales include expected future inflation, they should be

adjusted as follows. Accounts Receivable in the seller's books should
be discounted to present value and the difference adjusted to Net
Sales. Payables in the buyer's books should be discounted to present
value and the difference adjusted to Inventories.
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Comparative Financial Statements
The comparative financial statements for the previous year should

be restated by applying the annual variation in the official inflation
index to each item in order to ensure they are comparable under a
constant currency.
The Brazilian Experience
Companies
on the stock
exchange
In Brazil, the concepts of monetary correction discussed above are

valid only for companies listed in the stock exchange, since these
accounting principles are endorsed by the CVM (The Brazilian
Exchange Commission).
Companies not
on the stock
exchange
For companies not listed in the stock exchange, the GAAP governing
monetary correction of financial statements as specified by the
Corporations Law is less complete. In these cases, only Permanent
Assets and Equity accounts are monetarily corrected, with the
difference between original and restated value grouped under the
heading of Result of the Monetary Correction of the Balance Sheet.
For comparison purposes, income for the current year and the
previous year's figures are not restated.
Therefore, financial statements prepared in accordance with the
Corporations Law only partially reflect the effects of inflation. To
gain a thorough understanding of a company's financial position, the
analyst will have to make the additional adjustments described above in
the comprehensive monetary correction procedure.
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1-33
FINANCIAL ANALYSIS SPREADSHEETS

Used by banks
to spread
client financial
numbers
For many years, virtually all banks have used a financial analysis
spreadsheet to spread client financial numbers into a more
manageable, useful, and standardized format. The spreadsheet captures
client information in separate columns for each year or period,
thereby facilitating comparison and enabling trend analysis.
For most types of companies, the standard spreadsheet contains:
n
A balance sheet
An income statement
Fixed asset and net worth reconciliations
Ratios and percentages
A funds flow statement (in many cases)
Fundamentally different businesses (banks or insurance companies,

for example) may require different spreadsheets to facilitate numbers
analysis.
Before the arrival of the personal computer in the early 1980s, this
process was done entirely by hand on a sheet of paper. Now, it is done
electronically on a computer screen using sophisticated software
(such as Microsoft Excel), enabling a tremendous jump
in productivity and depth over earlier manual processes.
Changed 07/02/96
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Citibank
electronic
spreadsheet
model
In late 1995, after many years of using a standard format either on

paper or by electronic means derived from the original manual format,
Citibank in Latin America developed a new and more comprehensive
electronic spreadsheet model. The new model goes beyond capturing
numbers for analysis; it incorporates business risk assessment and
financial risk rating. It also features indexing of accounts and includes
greater detail in certain account reconciliations and ratio calculations.
Know how the

model works
To make optimal use of these formats, the analyst should clearly

understand the details and nuances of how they work. Calculations are
the result of formulas, not magic, and it is important to understand that
designing a model involves some trade offs. As
we discuss ratios in a later unit, you will see that there may be more
than one way to calculate a ratio. Some calculations give more
accurate results than others; but, if the necessary information is
unavailable, we may have to settle for a second choice.
In certain cases, the method used for calculating a ratio may make
a significant difference in the results. It is up to the analyst to get
the additional information and make the appropriate calculations to
achieve a more in-depth, meaningful financial analysis. The analyst
must understand where the numbers come from and where the weak
points of the model may leave results open to questionable
interpretation.
An example of this may be seasonality of financial numbers, where
ratios calculated from end-of-period numbers may be distorted from
reality. Improper conclusions may result if the analyst does not
understand the effect. We will discuss this point later in the units
dealing with financial ratios.
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Summary
In an environment of prolonged periods of inflation or high inflation
rates, financial statements have meaning only when they are adjusted
to recognize the effects of inflation.
Problems
In periods of high inflation, the balance sheet may reflect historical

values, present value, or future value. As a result, accounts may be
either overstated or understated.
In inflationary environments, results reported in the income statement
appear to grow over time. Even when operating volumes remain
constant, income and expense figures continue to grow.
Solutions
These problems are solved by using either foreign currency

(e.g. US dollars) accounting or constant currency accounting.
US dollar accounting is an unofficial accounting method used by
companies in countries where the US dollar is more stable than local
currency. Constant currency accounting is a method of keeping

accounts in an indexed, hypothetical currency.
Adjustments
As a result of inflation, monetary assets generate losses; monetary

liabilities generate gains. These variances should be calculated and
accounted for in the income statement. The asset or equity balance for
non-monetary items should then be restated to current price levels in
the Balance Sheet.
Remunerated
monetary items
When inflation has been constant for a long time, assets and liabilities
must be protected with instruments requiring compensation for
variance in the official inflation indices to
prevent the loss of value.
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Adjustments
to expected
inflation
When receivables and payables include expected future inflation, they

should be discounted to present value and adjusted to Net Sales and
Inventories, respectively, to reflect the actual value of the obligation.
Restatement for
comparative
analysis
Comparative financial statements from the previous year should be

restated to reflect the annual variation in the official inflation index
for purposes of comparative analysis.
You have completed Unit One: Accounting Issues in Financial Analysis. Please answer the
questions in Progress Check 1.2 to check your understanding of the material before
proceeding to Unit Two: Basic Concepts of Financial Analysis.
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PROGRESS CHECK 1.2
material.
Question 9: Monetary gains on remunerated items are a type of:
____ a) income that originates from monetary correction of liabilities.
____ b) expense that originates from monetary correction of liabilities.
____ c) income that originates from monetary correction of assets.
____ d) expense that originates from monetary correction of assets.
Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary
correction for that year is 250%, and losses are adjusted to official inflation
indices, we may say that the company owes:
____ a) $250 at the end of the year and has incurred a remuneration of $150
(expense).
____ b) $250 at the end of the year and has been remunerated $150 (income).
____ c) $350 at the end of the year and has been remunerated $250 (income).
____ d) $350 at the end of the year and has incurred a remuneration of $250
(expense).
Question 11: Read the following statements about constant currency accounting then
indicate whether they are true or false by marking with a "T" or "F."
____ a) The nominal value of monetary items remains constant over time.
____ b) Accounts payable are non-monetary items.
____ c) Inventories are monetary items.
____ d) Non-monetary items maintain their actual (intrinsic) value.
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ANSWER KEY
Question 9: Monetary gains on remunerated items are a type of:

a) income that originates from monetary correction of liabilities.
Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary
correction for that year is 250%, and losses are adjusted to official inflation
indices, we may say that the company owes:
d) $350 at the end of the year and has incurred a remuneration of $250
(expense).
Question 11: Read the following statements about constant currency accounting then
indicate whether they are true or false by marking with a "T" or "F."
T
a) The nominal value of monetary items remains constant over time.
b) Accounts payable are non-monetary items.
c) Inventories are monetary items.
d) Non-monetary items maintain their actual (intrinsic) value.
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PROGRESS CHECK 1.2

(Continued)
Question 12: When goods are sold for payment in 60 days:

____ a) the total of trade receivables undergoes monetary correction every month,
and the difference is accounted for as financial income.
____ b) the amount of the bill remains the same until payment.
____ c) after 60 days, the company records a loss caused by inflation for
the period.
____ d) there are no inflation gains or losses, since the company could sell
for cash and invest the proceeds in the money market.
Question 13: Monetary correction is a methodology used to index prices in an inflationary

economy. Indicate whether the following statements are true
or false by marking "T" for true or "F" for false.
____ a) Inflation gains and losses do not necessarily reflect cash inflows and
outflows during the year in which they occur.
____ b) The values of inventories which remain with the company for long periods
are lower than current market prices.
____ c) Monetary correction of remunerated liabilities generates financial
expense.
____ d) Effects of inflation are the net of gains and losses on monetary items.
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ANSWER KEY
Question 12: When goods are sold for payment in 60 days:

b) the amount of the bill remains the same until payment.
Question 13: Monetary correction is a methodology used to index prices in an inflationary

economy. Indicate whether the following statements are true
or false by marking "T" for true or "F" for false.
T
a) Inflation gains and losses do not necessarily reflect cash inflows and
outflows during the year in which they occur.
b) The values of inventories which remain with the company for long periods
are lower than current market prices.
c) Monetary correction of remunerated liabilities generates financial

expense.
d) Effects of inflation are the net of gains and losses on monetary items.
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PROGRESS CHECK 1.2

(Continued)
Use the information which follows to complete both Questions 14 and 15.
Question 14: Fill in the blanks on the following calculation of the effects of inflation.
Assume that:
n
The inflation index for the period is 10%
Both the marketable securities and loans payable are subject to monetary
correction
Opening balances:
Assets
Liabilities
Cash
Marketable Securities
Fixed Assets
60
100
780
Total
940
Accounts Payable
Loans
Equity
160
300
480
940
Calculations:
Gains on remunerated monetary assets
Losses on remunerated monetary liabilities
____________
(___________)
Monetary correction of fixed assets

Monetary correction of equity
____________
(___________)
Total effect of inflation
____________
Represented by:
Losses on non-remunerated monetary assets
Gains on non-remunerated monetary liabilities
(___________)
____________
____________
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ANSWER KEY
Question 14: Fill in the blanks on the following calculation of the effects of inflation.
Assume that:
n
The inflation index for the period is 10%
Both the marketable securities and loans payable are subject to monetary
correction
Opening balances:
Assets
Liabilities
Cash
Fixed Assets
60
100
780
Total
940
Accounts Payable
Loans
Equity
160
300
480
940
Calculations:
Gains on remunerated monetary assets
Losses on remunerated monetary liabilities
Monetary correction of fixed assets
Monetary correction of equity
10
30
78
48
Total effect of inflation
10
Represented by:
Losses on non-remunerated monetary assets
Gains on non-remunerated monetary liabilities
6
16
10
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PROGRESS CHECK 1.2

(Continued)
Question 15: After all adjustments are made, the balance sheet will appear as follows:
Assets
Liabilities
Cash
Fixed Assets
_____
_____
_____
Total
_____
Accounts Payable
Loans
Equity
_____
_____
_____
_____
Question 16: Select three features of the electronic spreadsheet model developed by
Citibank in Latin America.
____ a) Formula selection
____ b) Business risk assessment
____ c) Automatic monetary corrections
____ d) Financial risk rating
____ e) Account indexing
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ANSWER KEY
Question 15: After all adjustments are made, the balance sheet will appear as follows:
Assets
Cash
Fixed Assets
Total
Liabilities
60
110
858
Accounts Payable
Loans
Equity
1,028
160
330
538
1,028
Composition of Equity
Opening Balance
+ Monetary Correction
+ Net Income
480
48
10
Closing Balance
538
Question 16: Select three features of the electronic spreadsheet model developed by
Citibank in Latin America.
b) Business risk assessment
d) Financial risk rating
e) Account indexing
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Unit 2
UNIT 2: BASIC CONCEPTS OF FINANCIAL ANALYSIS

INTRODUCTION
In Unit One, we discussed some of the accounting issues that affect the preparation of
financial statements. By now, you should recognize that financial analysts must get
behind the numbers by considering certain accounting-related issues to understand the
true financial picture of a company. In this unit, we will focus on other areas of
consideration, including analyzing the funds flow within a company and measuring its
working capital needs. These basic concepts will enable you, the analyst, to probe
deeper in search of more reliable conclusions concerning a company's financial health.
UNIT OBJECTIVES

n
Define liquidity and recognize its impact on the financial position of a

company
Compute working capital and determine whether it is positive or negative
Distinguish between third party capital and own capital
Classify assets, liabilities, and net worth accounts as either a use or source of
funds
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BASIC CONCEPTS OF FINANCIAL ANALYSIS
LIQUIDITY
Degree of Liquidity
Varies with
type of asset
The liquidity of an asset, as determined by economic factors affecting

supply and demand, varies with the type of asset and, in some cases,
with time. For example, certain government securities can be realized
overnight, some receivables can be realized in 30 days or less, but it
takes longer to sell a large industrial building.
The seasonality of an item may also affect its liquidity; for example, a
heavy coat will be more marketable during the winter season than in
the hot summer months.
Some assets, such as claims, are liquid by nature. These include
checks, trade bills, and contracts where liquidity is determined by
the parties. For instance, a check is a claim to receive cash at sight
all the holder has to do in order to realize it is to present it at the bank.
A sale that is negotiated for payment in 10, 30, or 60 days generates a
trade bill that expresses the claim to receive cash at the specified
time.
Importance of Liquidity
Companys
ability to meet
obligations
on time
Liquidity is important because it sustains the ability of an enterprise to

meet its obligations in a timely manner. As an analyst, it is vital
to understand this concept since the definition of insolvency is the
inability of a firm to meet its obligations as they mature. The penalty
for lack of liquidity is very high, including the possibility of
bankruptcy if the creditors attempt to collect through the courts.
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Increasing Liquidity
Timely
management
strategies
Installing timely management strategies can increase asset liquidity.

For example:
n
Payment delays may be reduced by efficient credit and

collection procedures.
Inventories may be sold faster if they are advertised and

promoted or if they are perceived to be of higher quality than
the competition.
Liquidity and Balance Sheet Structure

Liquidity also affects the structure of the balance sheet. The asset
accounts are listed in the order of their liquidity current assets
first, fixed assets second, and other assets last. Individual current
accounts are also ranked by their degree of liquidity. For instance,
cash is the most liquid account and is, therefore, listed first among the
current assets.
TYPES OF CAPITAL
Working Capital
Resources to
meet day-today needs
Working capital is the amount of resources available to meet a

company's day-to-day needs, such as paying expenses or debts
incurred to purchase current assets. The difference between current
assets and current liabilities determines the amount of working capital
the net current assets on the balance sheet. In accounting terms, it
is the part of current assets that is not financed by current liabilities.
In general, the greater the amount of working capital, the greater the
liquidity. In Unit Four, we will demonstrate that the current ratio,
which represents the coverage of current assets over current
liabilities, is a traditional measure of liquidity.
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Working capital
from the funds
flow perspective
In Figure 2.1, you can see the concept of working capital from
the funds flow perspective of how funds actually flow within a
company. We will discuss funds flows in greater detail later in
this unit.
Supplier
Payroll
Inventories
Income
Cash
Receivables
Bank Loans
Figure 2.1: Working capital
Working capital flows are not homogeneous; funds flow in and out in
different volumes and at different times in response to seasonality of
sales, purchases, and work flow.
Positive /
negative
working
capital
The amount of a companys working capital may be positive or

negative. We can determine this by subtracting current liabilities from
current assets.
Working Capital = Current Assets Current Liabilities
If current assets are greater than current liabilities, working capital is

positive. If current assets are less than current liabilities, working
capital is negative. These concepts are shown in Figures 2.2 and 2.3.
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CURRENT ASSETS
2-5
CURRENT
LIABILITIES
Positive working capital
Figure 2.2: Positive working capital current assets > current liabilities
CURRENT ASSETS
CURRENT
LIABILITIES
Negative working capital
Figure 2.3: Negative working capital current assets < current liabilities
Timing of
cash flows
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The definition of working capital is somewhat generalized because

it is based on volume only. A better measure of a company's working
capital also includes the element of time. Time indicates when inflows
and outflows will take place in all asset and liability accounts. Time
and volume together provide a more exact picture
of a company's working capital.
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Permanent Capital
Non-current
assets funded by
long-term debt
Permanent capital, in a generic sense, is comprised of non-current

assets (e.g., land, buildings, furniture, equipment, etc.) in relation
to long-term liabilities (e.g., long-term debt, etc.) and shareholders
equity (net worth). Non-current assets should be funded by long-term
financing or permanent funds. This is illustrated in Figure 2.4, below.
LIABILITIES &
NET WORTH
ASSETS
Long-term assets
Permanent
Long-term debt
or
Fixed Assets
PPE
Investments
Deferred charges
NonCurrent
Capital
Shareholders Equity
Capital stock
Reserves
Retained earnings
Figure 2.4: Permanent capital Non-current assets funded by

long-term debt
We know that net worth is the interest investors have in the assets of
an enterprise after satisfaction of liabilities owed to the company's
creditors. Net worth represents an important part of a company's
permanent capital and should be used to support fixed assets and
investments. Any excess of net worth over fixed and other non-current
assets is then available for funding working capital.
If net worth is lower than permanent assets (fixed assets), the
difference on the balance sheet will be funded by outside capital. This
outside source of funds will also cover the working capital financing
needs. The following example of Alpha Company illustrates this point.
Current Assets
Fixed Assets
Total
$200
300
$500
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Current Liabilities
Net Worth
Total
$150
350
$500
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Notice that there is a $50 difference between net worth and fixed
assets. Since net worth is greater, the difference ($50) in effect serves
to provide funds for working capital. The proportion of a companys
own resources used for funding fixed assets is greater than 100%, so
14% of net worth is used to fund the company's working capital.
Now suppose Alpha Company purchases a new plant for $100 that is
financed by long-term loans.
Current Asset
Fixed Assets
Total
$200
400
$600
Current Liabilities
Long-term Liabilities
Net Worth
Total
$150
100
350
$600
Fixed assets increase from $300 to $400 and total long-term

liabilities increase by the same $100. Fixed assets are now covered by
$350 in net worth and by $50 in long-term debt. Since the entire net
worth is used to cover fixed assets, current assets are funded entirely
by outside capital.
Third Party and Own Capital

Another way to look at liabilities and net worth is to see liabilities as
third party capital and net worth as own capital. These concepts are
discussed below and illustrated in Figure 2.5.
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Third Party Capital
Outside capital represents the company's indebtedness to third parties

and represents obligations to pay sums of money at some future date.
Third party capital may be classified as:
n
Current liabilities liabilities maturing within one year
Long-term liabilities liabilities maturing after one year
Third party capital also may be divided into:

n
Operating credits, which arise from a company's operations

and include trade payables as well as accrued taxes and
similar obligations
Financial credits, which reflect loans from financial

institutions, bond holders, shareholders, or affiliates
Own Capital
Own capital represents the owners' investment in the company plus the
wealth accumulated by the company from its business earnings. It is
divided into:
n
Paid-in capital the amount actually invested by the owners

which usually remains in the company forever. It is only
returned to the owners, in whole or in part, in very rare cases
when a company is dissolved or its capital reduced.
Retained earnings the wealth accumulated by the

company as a consequence of its profitable operations
over a number of years. Eventually, retained earnings are
capitalized or paid out as dividends. Companies with
unprofitable operations have accumulated losses. Many
companies have unprofitable periods now and then, but in
grave situations, the company may need additional capital
injections to prevent insolvency.
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Current Liabilities
Long-Term Liabilities
Operating Credits
OR
Financial Credits
Third Party
Capital
Paid-in Capital
Own Capital
Retained Earnings
Figure 2.5: Third party capital and own capital
Difference Between Liability and Net Worth Financing

A company may finance its operations by increasing liabilities
by increasing net worth. Both methods have advantages and
disadvantages and they must be skillfully combined by management to
optimize sourcing.
Own capital is always the basic source of financing because it
represents the owners' commitment. No financial institution will lend
money to a company if the owners are not sufficiently committed. Net
worth financing does not bear interest and does
not have to be repaid.
But it would be an error to finance a company solely with the owners'
resources. Here are several reasons:
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Interest is a cost of doing business and is, therefore, taxdeductible. This means that interest expense is always
lower than a first look at the income statement would lead
us to think.
Liability financing does not tie up owners' capital. This

means that a financial manager can attain greater flexibility
to cover temporary cash needs.
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Own capital dilutes earnings per share and dividends.

A company whose profit ratios are higher than interest rates can
usually maximize earnings per share by using bank and suppliers'
credits. This is the concept of leverage that will
be covered in Unit Three: Financial Statement Analysis.
SUMMARY
Liquidity is the ability of an enterprise to convert assets into cash or

equivalent, without significant loss, to meet the financial obligations
of the debtor.
Asset realization times may be affected by economic issues and by
seasonal factors affecting supply and demand.
As an analyst, you should have a feeling for the liquidity of a company
when evaluating its financial health because liquidity determines the
company's viability on a short-term basis.
Management strategies such as these will help increase asset
liquidity:
n
Effective credit and collection procedures to prevent

receivables backlogs
Advertising and promotions to increase inventory turnover
In most countries, asset accounts appear in the balance sheet in the

order of their liquidity current assets are listed first. The same
order is followed within account groups the most liquid account is
listed first. If this is not the system used in your country, you should
reclassify the accounts for analysis purposes.
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Working capital is the difference between current assets and

current liabilities. It represents the resources available to meet the
companys day-to-day needs. In general, the greater the amount
of working capital, the greater the liquidity.
Sources of funds are classified on the balance sheet as either:
n
Third party capital
Own capital
Third party capital represents the company's indebtedness and claims

to future payments. These include:
n
Operating credits such as trade bills, accrued payroll,

or taxes
Financial credits such as loans granted by banks,

shareholders, affiliates, or debentures
Own capital represents the owners' investment in the company and the
accumulated wealth generated from doing business. Own capital
includes:
n
Paid-in capital
Retained earnings
Distinctions between third party capital and own capital are important
because of the obligations and privileges associated with them. Third
party capital is an obligation to be paid, while paid-in capital carries
incidence of ownership and the right to profits.
As an analyst, you also need to be aware of a company's working and
permanent capital. Working capital is the difference between current
assets and current liabilities; whereas permanent capital is
the relationship between non-current assets, long-term liabilities,
and shareholders' equity.
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You have completed the first section of Unit Two. Please complete
Progress Check 2.1 before continuing to the final section of this unit
which covers Sources and Uses of Funds.
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PROGRESS CHECK 2.1
material.
Question 1: Liquidity is:
____ a) the ability of an enterprise to meet its obligations without delay.
____ b) all measurable resources available to the company for use in its operation.
____ c) the cash value of the company's assets.
____ d) the net income of an enterprise.
Question 2: The degree of liquidity of an asset is determined by its:

____ a) cost.
____ b) market value.
____ c) degree of convertibility to cash.
____ d) age.
Question 3: Number the following assets (1-3) to indicate the degree of liquidity.
(1 for most liquid)
____ Ten-floor city building
____ Balances on demand deposits
____ Car
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ANSWER KEY
Question 1: Liquidity is:

a) the ability of an enterprise to meet its obligations without delay.
Question 2: The degree of liquidity of an asset is determined by its:

c) degree of convertibility to cash.
Question 3: Number the following assets (1-3) to indicate the degree of liquidity.
(1 for most liquid)
3
Ten-floor city building
Balances on demand deposits
Car
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PROGRESS CHECK 2.1

(Continued)
Question 4: A lack of liquidity may lead a company to:

____ a) prepay its obligations.
____ b) acquire fixed assets.
____ c) make sales with greater credit terms.
____ d) bankruptcy.
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ANSWER KEY
Question 4: A lack of liquidity may lead a company to:

d) bankruptcy.
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PROGRESS CHECK 2.1

(Continued)
Question 5: Look at the following list of funds movements that relate to working capital.
Write the letter of each item in the appropriate circle in the diagram below.
The first one serves as an example.
a) Raw materials purchased on credit
h) Payment to suppliers
b) Factory payroll (blue collar workers)
i) Repayment of bank loans
c) Working capital loans

d) Work in process (unfinished goods)
j) Total payroll (white and blue collar

workers)
e) Goods sold on credit
k) Commissions paid to salespersons
f) Profit from sales
l) Goods sold on cash basis
g) Collection of trade receivables
m) Sale of finished goods

n) Raw materials used in production
BANK LOANS
SUPPLIERS
a
RAW MATERIALS
INVENTORIES
WORK IN PROCESS
INVENTORIES
CASH
PAYROLL
FINISHED GOODS
CUSTOMERS
SALES
COMMISSIONS PAID
TO SALESPERSONS
PROFITS
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ANSWER KEY
Question 5: Look at the following list of fund movements that relate to working capital.
Write the letter of each item in the appropriate circle in the diagram below.
BANK LOANS
SUPPLIERS
a
c
RAW MATERIALS
INVENTORIES
WORK IN PROCESS
INVENTORIES
CASH
PAYROLL
b
d
FINISHED GOODS
CUSTOMERS
COMMISSIONS PAID
TO SALESPERSONS
SALES
f
PROFITS
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PROGRESS CHECK 2.1

(Continued)
Question 6: Look at the current assets and current liabilities from the balance sheet
of ABC, Inc. Using this information, calculate the working capital for
each year.
ABC, Inc.
ASSETS
19X1
19X2
LIAB. & NET WORTH
19X1
19X2
Cash
Receivables
Inventories
Other
24
93
126
15
42
119
109
37
Suppliers
Loans
Payroll
Other
33
38
34
11
26
82
40
31
Current Assets
258
307
Current Liabilities
116
179
Legal Deposits
Inter-company Loans
109
6
125
31
Loans
Debenture Bonds
109
6
94
36
Other Assets
115
156
115
130
169
276
137
169
287
152
Investments
PPE
Deferred Charges
33
374
33
46
357
51
Capital Stock
Reserves
Retained Earnings
Fixed Assets
440
454
Net Worth
582
608
TOTAL LIAB. & NET WORTH
813
917
TOTAL ASSETS
813
917
19X1
19X2
Working Capital
$______
$______
Is the working capital positive or negative?
19X1 _______________
19X2 _______________
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ANSWER KEY
Question 6: Look at the current assets and current liabilities from the balance sheet
of ABC, Inc. Using this information, calculate the working capital for
each year.
19X1
19X2
Working Capital
$_142__
Is the working capital positive or negative?
19X1
positive
19X2
positive
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$_128_
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PROGRESS CHECK 2.1

(Continued)
Question 7: Look at the following list of movements that relate to permanent capital.
Write the letter for each item in the appropriate circle in the diagram below.
a) Capital investments by shareholders
b) Obtaining a fixed asset loan
c) Investments in affiliates
d) Loans to affiliates
e) Loan repayments
f) Dividend payments
SHAREHOLDERS
LOANS TO ASSOCIATED AND

CONTROLLED COMPANIES
CASH
STOCK IN OTHER
COMPANIES
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BANK LOANS
MACHINERY AND
EQUIPMENT
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ANSWER KEY
Question 7: Look at the following list of movements that relate to permanent capital.
Write the letter for each item in the appropriate circle in the diagram below.
a) Capital investments by shareholders
b) Obtaining a fixed asset loan
c) Investments in affiliates
d) Loans to affiliates
e) Loan repayments
f) Dividend payments
SHAREHOLDERS
LOANS TO ASSOCIATED AND

CONTROLLED COMPANIES
CASH
STOCK IN OTHER
COMPANIES
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BANK LOANS
MACHINERY AND
EQUIPMENT
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PROGRESS CHECK 2.1

(Continued)
Question 8: Classify the following accounts as either (T) third party capital or (O) own
capital. The first one serves as an example.
T
Accrued payroll and taxes

Notes payable
Capital stock
Trade bills (accounts payable)
Bank loans
Reserves
Inter-company loans
Retained earnings
Rent and utilities
Question 9: Classify the following accounts as either (O) operating credits or (F)
financial credits.
____ Loans
____ Accrued taxes
____ Debenture bonds
____ Trade bills
____ Accrued payroll and payroll taxes
____ Inter-company credits
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ANSWER KEY
Question 8: Classify the following accounts as either (T) third party capital or (O) own
capital. The first one serves as an example.
T
Accrued payroll and taxes
Notes payable
Capital stock
Trade bills (accounts payable)
Bank loans
Reserves
Inter-company loans
Retained earnings
Rent and utilities
Question 9: Classify the following accounts as either (O) operating credits or (F)
financial credits.
F
Loans
Accrued taxes
Debenture bonds
Trade bills
Accrued payroll and payroll taxes
Inter-company credits
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PROGRESS CHECK 2.1

(Continued)
Question 10: Study the liabilities of the following companies and fill in the blanks below.
COMPANY A
Liabilities & Net Worth
Current Liabilities
Shareholders Equity
Total
COMPANY B
$350
$300
$550
$1,200
Current Liabilities
$500
Shareholders Equity
$700
Total
$1,200
a) Third party capital:
Company A $___________________
Company B $___________________
b) Own capital:
Company A $___________________
Company B $___________________
c) Company
uses a larger proportion of third party capital than Company
d) The current liabilities of Company

e) The own capital of Company
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are lower than those of Company
is higher than the own capital of Company
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.
.
.
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ANSWER KEY
Question 10: Study the liabilities of the following companies and fill in the blanks below.
COMPANY A
Current Liabilities
Shareholders Equity
Total
COMPANY B
$350
$300
$550
$1,200
Current Liabilities
$500
Shareholders Equity
$700
Total
a) Third party capital:
Company A $ 650
Company B
$ 500
b) Own capital:
Company A $ 550
Company B
$ 700
$1,200
c) Company A uses a larger proportion of third party capital than Company B .

d) The current liabilities of Company A are lower than those of Company B .
e) The own capital of Company B is higher than the own capital of Company A .
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SOURCES AND USES OF FUNDS
Sources and Uses in the Balance Sheet

Assets as
funds uses
Some uses of funds are obvious. For example, a company uses funds
to increase assets, such as the purchase of inventories or a new plant
building. However, not all uses of funds are so obvious; a company
may use funds to extend credit to its customers, or just to increase its
bank balances.
Liabilities and
net worth as
funds sources
The funds used to purchase or acquire assets are sourced from bank
loans, supplier credit, stockholders' equity, etc. These sources of
funds are the liabilities and net worth accounts listed in the balance
sheet. This concept is illustrated in Figure 2.6.
ASSETS
Uses of Funds
LIABILITIES &
NET WORTH
Sources of Funds
Figure 2.6: Funds uses and sources
Taking a closer look, you can see that assets, liabilities, and net
worth can be both sources and uses of funds. In Figure 2.7, we
show that assets can be sources if they are reduced e.g., reducing
a checking account balance to purchase a property. In this example, one
asset account (cash) is reduced in exchange for another asset account
(property), but the total assets remain the same.
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An asset reduction may also be a source for reducing a liability e.g.,

using cash to pay a bank loan. In this case, as you can also see in Figure
2.7, a reduction in the liability is a use of funds because resources
(assets) are reduced to repay the loan.
ASSETS
Buy Property
Decrease
Resources
Increase Assets
Sell Property
Decrease Assets
Increase Resources
Source of Funds
Use of Funds
LIABILITIES & NET WORTH

Borrow Funds
Increase Liabilities &

Net Worth
Repay Loan
Decrease Liabilities
& Net Worth
Increase
Resources
Sources
of Funds
Reduce
Resources
Use of
Funds
Figure 2.7: Assets, liabilities, and net worth can be both uses and
sources of funds
On the asset side of the balance sheet, the purchase of an asset is a use
of funds; sale of an asset is a source of funds. On the liabilities and net
worth side of the balance sheet, an increase in liabilities or net worth
is a source of funds; a reduction in liabilities or net worth is a use of
funds. A use of fund, therefore, is an increase in an asset account or a
decrease in a liability or net worth account. Conversely, a source of
funds is a decrease in an asset or an increase in a liability or equity
account.
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BALANCE SHEET
ASSETS
LIABILITIES &
NET WORTH
Use of Funds:
(+) Increase
(-) Decrease
Source of Funds:
(-) Decrease
(+) Increase
Figure 2.8: Effect on the balance sheet of uses and sources of funds
Operating / Non-Operating
We have seen that changes in assets, liabilities, and net worth accounts
can be identified as sources or uses. Lets add another concept to this.
These changes also can be identified as operating sources / uses or
non-operating sources / uses, depending on the
type of account.
Operating Sources and Uses
Normal day-today operations
of the company
Operating sources and uses refer to those assets and liabilities

principally associated with the normal day-to-day operations of the
company. These are basically current assets or current liabilities, with
some exceptions. We do not include cash or cash equivalent assets
within the current assets and we do not include short-term bank debt
within the current liabilities. You will see the reason for these
exclusions as you continue to read.
The most typical examples of operating sources and uses are:
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Increase / decrease in accounts receivable
Increase / decrease in inventory
Increase / decrease in accounts payable
Increase / decrease in accruals

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Non-Operating Sources and Uses

All other
accounts
Non-operating sources and uses pertain to practically all other assets,

liabilities, and equity accounts, including one of the exceptions listed
above short-term bank debt. The most common examples are:
n
Plant and equipment (P+E) expenditures
Increase in long-term investments
Takedown or repayment of short-term bank debt
Take down or repayment of long-term bank debt
Dividends
By describing the changes in the balance sheet accounts as sources and

uses, and as operating and non-operating, we can construct a funds
generation statement which allows a better understanding of past funds
generation ability and future capacity. In doing this, we are able to
isolate the funds generated from normal operations that enable the
payment of bank debt and dividends, and contribute to plant and
equipment expenditures and other non-operating needs.
First, lets consider the income statement from the sources / uses
perspective as well.
Sources and Uses in the Income Statement

Sales revenues
vs. costs and
expenses
Sources and uses of funds also appear in the income statement: sales
represent revenues, which are sources of funds; costs and expenses
represent uses of funds. The net result of revenues minus expenses
is either a profit (a source of funds) or a loss (a use of funds). The
flows are the same for all companies, but volumes of funds,
maturities, and realization times will vary from firm to firm.
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INCOME STATEMENT
Depreciation
and other noncash charges
Revenue
(+) Source of Funds
Expense
(-) Use of Funds
Depreciation also plays an important role within the income

statement. Depreciation is a non-cash charge against earnings for
which there is no corresponding outflow of funds. However,
since the amount is charged against earnings, from the funds flow
perspective, the net income is understated by this amount. Therefore,
for purposes of funds flow analysis, the depreciation must be added
back to the net income as if it were a source of funds.
Together, net income, depreciation, and other non-cash charges
are considered to be the gross operating funds generation of the
company. Examples of other non-cash charges include depletion
of wasting fixed assets, amortization of intangibles, bad debt and
inventory write-offs, foreign exchange losses, and certain inflation
adjustments.
Funds Generation Statement

Gross operating
funds
generation
Putting all this together, we can construct a funds generation

statement. We start with net income (the net sources from the income
statement) and add depreciation to obtain gross operating funds
generation. We also add other non-cash charges, if there
are any.
Net operating
funds
generation
Next, we subtract operating uses and add operating sources to

determine net operating funds generation. This is the most
important number because it tells the analyst the amount of funds the
company has generated (or will be generating if the numbers are
projections) to pay bank debt and dividends, and contribute to other
non-operating needs such as plant and equipment expenditures.
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Free operating
cash flow
Note that the new Citibank spreadsheet now includes a certain portion
of plant and equipment expenditures in a special maintenance category
to reflect that P+E must normally be replenished to maintain existing
operational levels. Subtracting maintenance capital expenditures
from net operating funds generation results in the figure for free
operating cash flow.
P+E expenditures are separated between maintenance and expansion.
P+E expenditures for expansion are included within non-operating uses
along with dividends, payment of bank debt, and other such uses.
Increase /
decrease in
cash and cash
equivalent
The final number must be close to the increase or decrease in cash

and cash equivalent accounts from one accounting period to the
other. This is the check on the exercise. If the numbers do not check,
a mistake has been made by inputting incomplete or incorrect data.
+
+
+
=
Net income
Depreciation
Other non-cash charges
Gross operating funds generation
Operating uses (usually receivables and inventory)

+ Operating sources (usually payables and accruals)
= Net operating funds generation
Maintenance capital expenditures
= Free operating cash flow
Non-operating uses (usually P+E, dividends, bank debt payment)
+ Non-operating sources (usually new bank debt)
= Net increase / Decrease in cash and cash equivalents
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Summary of Sources and Uses

These relationships may be summarized as follows:
ASSET DECREASE
REVENUE
LIABILITIES & NET

WORTH INCREASE
Source
Source
Source
FUNDS
Use
Use
Use
ASSET INCREASE
EXPENSE
LIABILITIES & NET

WORTH DECREASE
Figure 2.9: Flow of funds summary for balance sheet and

income statement
Funds Flow Analysis

Focuses
on account
movements
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This type of analysis is extremely important because it focuses on

account movements from one period to another, rather than on static
numbers. It evaluates a company's financial statements from a funds
flow perspective (how funds are obtained, how they are deployed in
the company's operations, and how they are returned to the entities
that provided them). It also enables the analyst to determine where the
company's resources have been invested (uses of funds) and to
identify the sources of funding.
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This focus will then help answer the following questions:

1) What are the company's needs for financing working capital?
2) How have these needs been financed in the past?
3) What is the ability of the enterprise to replace fixed assets
or to cover debt service?
4) What is the recent situation with respect to cash generation
capacity?
SUMMARY
Analysis of sources and uses of funds is another way to look at a

company's accounts. Funds are sourced by borrowing, increasing
capital, or converting assets; funds are used to increase assets, reduce
liabilities, or pay dividends.
Sources and uses of funds are also reflected in the income statement.
Sales (revenues) represent sources of funds, whereas costs and
expenses represent uses of funds.
A funds flow analysis focuses on account movements from one period
to another. It helps to answer such questions as:
n
What are the company's needs for financing working capital?
How have these needs been financed in the past?
What is the ability of the enterprise to replace fixed assets or

to cover debt service?
What is the recent situation with respect to cash generation

capacity?
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PROGRESS CHECK 2.2
material.
Question 11: Mark each statement (T) true or (F) false.

____ a) For each use of funds, there is one or more source.
____ b) Changes in assets are always uses of funds.
____ c) A balance sheet does not show the daily flow of resources in a company,
but we may say that assets are uses of funds and liabilities are sources
of funds.
____ d) A decrease in assets is a source of funds.
____ e) A reduction in liabilities is a use of funds.
____ f) Revenues are a source of funds and expenses are uses of funds.
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ANSWER KEY
Question 11: Mark each statement (T) true or (F) false.

T
a) For each use of funds, there is one or more source.
b) Changes in assets are always uses of funds.
c) A balance sheet does not show the daily flow of resources in a company,
but we may say that assets are uses of funds and liabilities are sources
of funds.
d) A decrease in assets is a source of funds.
e) A reduction in liabilities is a use of funds.
f) Revenues are a source of funds and expenses are uses of funds.
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PROGRESS CHECK 2.2

(Continued)
Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The
first one serves as an example.
S
Capital increase
Supplier payments
Raw materials purchases
Bank loans
Collection of trade bills
Advances from customers
Dividend payments
Net income
Purchase of marketable securities
Profit on real estate sales
Tax payments
Purchase of affiliates' shares
Payroll disbursements
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ANSWER KEY
Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The
first one serves as an example.
S
Capital increase
Supplier payments
Raw materials purchases
Bank loans
Collection of trade bills
Advances from customers
Dividend payments
Net income
Purchase of marketable securities
Profit on real estate sales
Tax payments
Purchase of affiliates' shares
Payroll disbursements
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PROGRESS CHECK 2.2

(Continued)
Question 13: Look at the example and fill in the statements below:
Purchase
INVENTORIES
Consumption
Use
$300
a)
Source
$200
of resources were used to purchase inventories.
b) Funds created by consumption of inventory totaled $

c) The balance of inventories, $
inventories.
, represents the net amount of resources applied in
Sales on Credit
TRADE RECEIVABLES
Source
$100
Use
$150
a)
Collection
The increase in trade receivables generated by sales on credit totals $

of funds because the company uses its resources to finance its clients.
b) Collection of trade bills creates a source of funds in the amount of $
and is a
.
c) The resulting balance of $

from the above transactions represents the net amount
of resources which remain in use to finance customers.
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ANSWER KEY
Purchase
INVENTORIES
Use
$300
a)
Consumption
Source
$200
$ 300 of resources were used to purchase inventories.
b) Funds created by consumption of inventory totaled $ 200 .

c) The balance of inventories, $ 100 , represents the net amount of resources applied in
inventories.
Sales on Credit
TRADE RECEIVABLES
Source
$100
Use
$150
a)
Collection
The increase in trade receivables generated by sales on credit totals $ 150 and is a
use of funds because the company uses its resources to finance its clients.
b) Collection of trade bills creates a source of funds in the amount of $ 100 .

c) The resulting balance of $ 50 from the above transactions represents the net amount
of resources which remain in use to finance customers.
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PROGRESS CHECK 2.2

(Continued)
Credit Purchases
Source
$200
SUPPLIERS
Payments
Use
$180
a) A credit purchase is a source of funds, because suppliers are financing raw

materials in the amount of $
.
b) Payments to suppliers in the amount of $
represent a use of funds.
c) The resulting balance, $

, from the above transactions represents
a source of funds which remains in the hands of the company to finance
inventories.
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ANSWER KEY
Credit Purchases
Source
$200
SUPPLIERS
Payments
Use
$180
a) A credit purchase is a source of funds, because suppliers are financing raw

materials in the amount of $ 200 .
b) Payments to suppliers in the amount of $ 180 represent a use of funds.
c) The resulting balance, $ 20 , from the above transactions represents a source
of funds which remains in the hands of the company to finance inventories.
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PROGRESS CHECK 2.2

(Continued)
Question 16: The following flowchart shows the movement of funds among several
balance sheet accounts. Indicate whether each item is a (U) use of funds or
(S) source of funds and enter the balance for each account.
$5
SHAREHOLDERS
$ 135
SUPPLIERS
$ 50
CASH
$ 200
$ 100
TRADE RECEIVABLES
a) CASH
Balance
(
(
(
(
(
) $100
)
50
)
5
) 135
) $
INVENTORIES
d) TRADE RECEIVABLES
( ) $150
( ) 100
Balance
b) SUPPLIERS
Balance
$ 150
( ) $
e) SHAREHOLDERS
( ) $50
( )
5
Balance ( ) $
( ) $200
( ) 135
( ) $
c) INVENTORIES
( ) $200
( ) 150
Balance
( ) $
Question 17: Based on Question 16, write in the missing values:

USES
Cash
Trade Receivables
Inventories
TOTAL
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$
$
$
$
SOURCES
Suppliers
Shareholders
$
$
TOTAL
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ANSWER KEY
Question 16: The following flowchart shows the movement of funds among several
accounts. Indicate whether each item is a (U) use of funds or (S) source of
funds and enter the balance for each account.
$5
SHAREHOLDERS
$ 135
SUPPLIERS
$ 50
CASH
$ 200
$ 100
TRADE RECEIVABLES
a) CASH
Balance
$ 150
( U ) $100
(U)
50
(S)
5
( S ) 135
( U ) $ 10
d) TRADE RECEIVABLES
( U ) $150
( S ) 100
Balance
b) SUPPLIERS
Balance
( U ) $ 50
e) SHAREHOLDERS
( S ) $50
(U)
5
Balance ( S ) $45
( S ) $200
( U ) 135
( S ) $ 65
c) INVENTORIES
( U ) $200
( S ) 150
Balance
( U ) $ 50
INVENTORIES
Remember, cash in hand is an asset and, therefore, a

use of funds. Reduction of cash is a source of funds
to reduce debt or other obligations of the enterprise.
Question 17: Based on Question 16, write in the missing values:

USES
Cash
Trade Receivables
Inventories
$ 10
$ 50
$ 50
TOTAL
$ 110
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SOURCES
Suppliers
Shareholders
$ 65
$ 45
TOTAL
$ 110
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PROGRESS CHECK 2.2

(Continued)
Question 18: Consider the following funds movements and arrange them in order
to calculate:
Gross operating funds generation
__________
Net operating funds generation
__________
Free operating funds generation
__________
Net increase / decrease in cash and cash equivalent
__________
Funds Movements:
Increase in accounts payable
Increase in accounts receivable
Maintenance P+E expenditures
Depreciation
Dividends
Net income
200
300
200
150
100
500
Increase in inventory
Other non-cash charges
Payment of long-term bank debt
Increase in accruals
Expansionary P+E expenditures
Increase in short-term bank debt
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
___________________________________________
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400
100
100
100
200
200
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
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ANSWER KEY
Question 18: Consider the following funds movements and arrange them in order
to calculate:
+ Net income
+ Depreciation
+ Other non-cash charges
= Gross operating funds generation
500
150
100
750
- Operating uses
Increase in accounts receivable
Increase in inventory
300
400
700
+ Operating sources
Increase in accounts payable
Increase in accruals
200
100
300
= Net operating funds generation
350
- Maintenance P+E expenditures
200
= Free operating funds generation
150
- Non-operating uses
Expansionary P+E expenditures
Dividends
Payment of long-term debt
200
100
100
400
+ Non-operating sources
Short-term bank debt
200
200
= Net Increase / Decrease in cash + Cash equivalent
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Unit 3
UNIT 3: FINANCIAL STATEMENT ANALYSIS
INTRODUCTION
Financial statement analysis is a set of techniques used to evaluate a company's financial

and economic condition. The analysis begins with a firm's financial statements, but also
includes consideration of other issues such as the economy, political situations, markets,
products, competition, etc. These additional areas of focus provide a better understanding
of the firm's situation and facilitate the correct interpretation of a company's financial
position.
UNIT OBJECTIVES

n
Recognize financial statement limitations and how they can affect

credit decisions
Identify the techniques commonly used to analyze balance sheets and

income statements
Apply vertical analysis and horizontal analysis techniques to analyze

a company's financial condition
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FINANCIAL STATEMENT ANALYSIS
FINANCIAL STATEMENT LIMITATIONS

Imposed by
rules and
standards
Financial statements conform to certain rules and standards that allow

for easy reading and comprehension. These rules also impose some
limitations for a correct financial statement interpretation that may
affect credit decisions.
1) Financial statements show only facts that can be measured in
financial terms and, therefore, may not always present
an accurate picture.
For example, trademarks and patents could have greater
market values than their book values indicate. Also,
employees may be a company's greatest asset, but their value
is never shown in the balance sheet.
2) Preparation of financial statements is based on prices at the
time events occur and, as a result of inflation, those prices may
not be applicable at the balance sheet date.
This limitation can be significant in high inflationary
environments where prices can change daily. Indexation
systems, such as the one used in Brazil, have been instituted to
partly counteract the effects of these price changes see Unit
One for more information on monetary correction.
3) Company balance sheets are similar to snapshots taken
on a particular day, even though their resources are
continually flowing. Therefore, a balance sheet does not
reflect the company's financial situation for the entire year.
4) Financial statements are prepared for tax reasons, and many
companies will use every legal means to reduce their tax
burden a policy that may sometimes result in a distorted
earnings and financial picture.
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3-3
BUSINESS RISK ASSESSMENT

Factors to
consider
In addition to the limits imposed by the rules and standards for

preparing financial statements, analysts must recognize that financial
statements reflect only a portion of a company's condition. The
analyst must also consider the issues associated with Citibanks
business risk assessment process, including:
n
Economic environment
Market conditions
Type of business
Management
Economic Environment
Context for
financial
decisions
The objective of an analysis is to understand a company's financial

decisions and determine their impact. The overall economic context in
which those decisions are made must be noted. To achieve this, the
analyst should ask questions such as:
1) What is the economic situation of the country?
2) What economic policies were in force during the analysis
period?
3) Are the same economic policies still in effect?
4) Have those policies affected the company? Its income?
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Market Conditions
Performance
of the market
The performance of the market is an influencing factor when making

judgments concerning a company's performance. The analyst should
ask questions such as:
1) How did the market behave?
2) What are the demand and market characteristics?
3) Who are the competition and what are their strengths
and weaknesses?
Type of Business
Products,
trade terms,
seasonality
Understanding the firm's business provides greater depth to the

analysis and a more accurate conclusion about its financial and
economic situation. Again, the analyst needs to ask pertinent questions
such as:
1) What is the nature of the firm's product? How does it
affect the financial statements?
2) What are the norms in the economic sector for trade terms?
3) How seasonal is the firm's business?
4) If the business is seasonal, is the balance sheet date in
the peak season or in the slow season? For instance, are
inventories at their highest or lowest level?
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Management
Organization,
adaptability,
capability
The analyst needs to assess the capabilities of management in order to

understand the firm's financial strategies and draw conclusions
regarding the company's ability to achieve its stated financial
objectives. The analyst should ask questions such as:
1) How is management organized and how does it function?
2) How flexible is management in coping with changing economic
and market situations?
3) Is management effective and capable of taking the enterprise
forward?
You have just completed the first section of Unit Three. Please
complete the following Progress Check before continuing to the next
section, "Analysis Techniques."
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3-7
PROGRESS CHECK 3.1
material.
Question 1: Indicate whether the following statements are (T) true or (F) false.
____ a) The balance sheet presents a "static picture" of a company since it
shows assets and liabilities at a certain date, while cash flows are dynamic
and could show a different situation at another date.
____ b) Assets are always recorded at market value, which provides the most
accurate account of a company's worth.
____ c) Balance sheets are prepared based on historical data.
____ d) A deep analysis requires more than financial statement data. It involves
examining the company's market position, its dependence on raw
materials, and its customer base.
____ e) It is not necessary to evaluate the firm's management to accurately assess
its financial situation.
____ f) A solid company will not be shaken by government policies; it will
automatically adjust to changing market situations with no need for
internal changes.
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ANSWER KEY
T
a) The balance sheet presents a "static picture" of a company since it

shows assets and liabilities at a certain date, while cash flows are dynamic
and could show a different situation at another date.
b) Assets are always recorded at market value, which provides the most
accurate account of a company's worth.
c) Balance sheets are prepared based on historical data.
d) A deep analysis requires more than financial statement data. It involves

examining the company's market position, its dependence on raw
materials, and its customer base.
e) It is not necessary to evaluate the firm's management to accurately assess

its financial situation.
f) A solid company will not be shaken by government policies; it will

automatically adjust to changing market situations with no need for
internal changes.
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ANALYSIS TECHNIQUES
Common
techniques
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The financial analyst uses certain techniques to assess a companys

financial and economic condition. In the remainder of this unit, we
cover the first two of these methodologies: vertical analysis and
horizontal analysis. In Units Four through Seven, we explain the
various types of financial ratios and how they are applied in the
analysis process. Finally, in Unit Eight, we use case studies to
demonstrate how the last three techniques are applied.
n
Vertical analysis Converts financial statement accounts

of a period into percentages for comparison of one accounting
period to another
Horizontal analysis Tracks individual account growth rates

from one period to another, acting as an implicit indexation
which is useful in countries with high inflationary environments
Financial ratio analysis Universally accepted techniques

that focus on the relationships between accounts in the
financial statements; these techniques constitute the basis for
most financial analysis done by banks
Operating / non-operating funds generation analysis

Breaks down funds flows from one period to another into
operating and non-operating sources and uses of funds to detect
funds movements
Trends analysis and financial projection Technique

to project the basic financial statements using logical
assumptions based on trend analysis and specific
expectations; financial projections are done to anticipate
future funds needs and measure expected future solvency
and cash generation capabilities
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Cash flow budgeting Technique used to measure

anticipated cash needs and the timing of these needs by
focusing only on cash movements at shorter (weekly, monthly)
time intervals; this is especially useful for measuring seasonal
cash needs and repayment capabilities
VERTICAL ANALYSIS
Purpose
Identifies
application
of resources
Vertical analysis is a technique used to identify where a company has

applied its resources and in what proportions those resources are
distributed among the various balance sheet and income statement
accounts. The analysis determines the relative weight of each account
and its share in asset resources or revenue generation.
Balance Sheet
Percentage
of total assets
On the balance sheet, vertical analysis consists of converting each

item to a percentage of total assets. Let's look at the following
example:
ASSETS
19X0
19X1
19X2
108
972
541
3
25
13
309
1,084
1,186
6
21
22
248
1,667
1,328
4
28
22
TOTAL CURRENT ASSETS
1,621
41
2,579
49
3,243
54
Non-Current Assets
PPE
Deferred Charges
2,107
209
54
5
2,585
52
50
1
2,685
127
44
2
TOTAL NON-CURRENT ASSETS
2,316
59
2,637
51
2,812
46
TOTAL ASSETS
3,937
100
5,216
100
6,055
100
Current Assets
Cash
Trade Receivables
Inventories
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Rounding off to the nearest whole number, we find that the cash
account for 19X0 has a 3% share of total assets. The same analysis is
applied to the other asset accounts and to the liability and net worth
accounts. The results, expressed as percentages, can then be
compared from year to year. This comparative analysis is useful since
it highlights relative account movements that absolute figures may
not detect.
(NOTE: In some of the following examples, the percentage
figures may not add up due to rounding.)
19X0
19X1
19X2
Current Liabilities
Due to Banks
Trade Payables
Accruals
1,041
488
112
26
12
3
1,479
675
196
28
13
4
1,850
840
256
31
14
4
TOTAL CURRENT LIABILITIES
1,641
41
2,350
45
2,946
49
840
21
1,228
24
1,044
17
TOTAL LIABILITIES
2,481
63
3,578
69
3,990
66
Net Worth
Capital Stock
Retained Earnings
1,000
456
25
12
1,000
638
19
12
1,000
1,065
17
18
TOTAL NET WORTH
1,456
37
1,638
31
2,065
35
TOTAL LIABILITIES & NET WORTH
3,937
100
5,216
100
6,055
100
Long-Term Debt
This type of analysis is similar to funds flow analysis (discussed in

Unit Two) because it permits spotting relative movements on a
comparative basis. Vertical analysis is useful in highlighting relative
account changes and should be complemented by the funds flow
analysis which pinpoints the sources of the changes.
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Income Statement
On the income statement, vertical analysis is a universal tool for
measuring the firm's relative performance from year to year in terms
of cost and profitability. It should always be included as part of any
financial analysis. Here, percentages are computed in relation to net
sales which are considered to be 100%. This vertical analysis effort in
the income statement is often referred to as margin analysis, since it
yields the different margins in relation to sales.
Percentage
of net sales
Let's look at an example:
19X0
19X1
19X2
5,421
3,324
1,292
100
61
24
6,728
3,983
1,511
100
59
22
8,146
4,729
1,668
100
58
20
805
15
1,234
18
1,749
21
342
313
152
6
6
3
410
487
-88
6
7
-1
440
498
57
5
6
1
Earnings Before Tax
302
249
868
11
Income Tax
42
67
221
260
182
647
Net Sales
Cost of Goods Sold
SGA Expenses
Operating Profit
Depreciation
Financial Expense
+ Other Income, Net
Net Income
In the above income statement, the relative percentage numbers

(rounded to the nearest whole number) tell us more than the absolute
figures. On a comparative basis, the analyst can clearly discern the
cost relationships and trends from year to year. The causes of these
changes can then be more easily investigated.
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Summary
Our example of vertical analysis of the balance sheet and income
statement shows how much easier and faster it is to compare results
using this technique. This technique only identifies symptoms and, by
itself, is not enough to draw accurate conclusions. Its purpose is to
identify situations that require further analysis and more probing
questions, with the objective of understanding why
an event has occurred and what it means to the company's financial
situation. This analysis can then be complemented using additional
financial statement analysis techniques such as ratio and funds flow
analysis.
Before proceeding to the section on "Horizontal Analysis," please

check your understanding of "Vertical Analysis" by completing the
following Progress Check.
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PROGRESS CHECK 3.2
material.
Question 2: Write the letter of the definition next to the type of analysis it describes.
____ Vertical analysis
____ Horizontal analysis
____ Financial ratio analysis
____ Operating / non-operating funds generation analysis
____ Trends analysis and financial projection
a) Identifies types of cash flows from one period to another
b) Focuses the analysis on relationships between financial statement accounts
c) Creates assumptions about funding needs in the future based on cash generation
capabilities
d) Indicates changes in accounts from one period to the next
e) Focuses on the application of resources within an accounting period
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ANSWER KEY
Question 2: Write the letter of the definition next to the type of analysis it describes.
e
Vertical analysis
Horizontal analysis
Financial ratio analysis
Operating / non-operating funds generation analysis
Trends analysis and financial projection
a) Identifies types of cash flows from one period to another

b) Focuses the analysis on relationships between financial statement accounts
c) Creates assumptions about funding needs in the future based on cash generation
capabilities
d) Indicates changes in accounts from one period to the next
e) Focuses on the application of resources within an accounting period
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PROGRESS CHECK 3.2

(Continued)
Use this balance sheet for Question 3.

Jurure Company: Balance Sheet for 19X1
ASSETS
19X0
19X1
40
200
760
320
80
200
1
5
19
8
2
5
64
576
1,408
384
192
128
1
9
22
6
3
2
1,600
40
2,752
43
160
200
4
5
256
0
4
0
360
256
Investments
PPE
Deferred Charges
200
1,640
200
5
41
5
320
2,820
252
5
44
4
Non-Current Assets
2,040
51
3,392
53
TOTAL ASSETS
4,000
100
6,400
100
480
---120
480
200
120
12
---3
12
5
3
640
128
256
832
192
64
10
2
4
13
3
1
1,400
35
2,112
33
400
400
10
10
576
192
9
3
800
20
768
12
1,200
200
400
30
5
10
2,496
320
704
39
5
11
Net Worth
1,800
45
3,520
55
4,000
100
6,400
100
Cash
Trade Receivables
Inventories
Advances to Suppliers
Other
Current Assets
Legal Deposits
Inter-company Receivables
Long-term Receivables
LIABILITIES AND NET WORTH

Suppliers
Bank Loans
Accrued Payroll
Accrued Taxes
Dividends
Accounts Payable
Current Liabilities
Loans
Stockholders Credits
Capital Stock
Reserves
Retained Earnings
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PROGRESS CHECK 3.2

(Continued)
Question 3: Based on the vertical analysis of the financial statements of Jurure Company,
complete the following questions.
a)
In 19X0 and 19X1, most of the resources are applied to:

____ current assets.
____ property, plant, and equipment.
____ long-term receivables.
b) The percentage of own and outside capital in 19X0 and 19X1 is:
19X0
Outside Capital
Own Capital
Total Liabilities & Net Worth
19X1
_____%
_____%
100%
_____%
_____%
100%
c) The share of own capital from 19X0 to 19X1 increased from ____% to ____%. This
shows that the increase in own resources was proportionally (larger / smaller)
_________________ than the increase in outside resources.
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ANSWER KEY
Question 3: Based on the vertical analysis of the financial statements of Jurure Company,
a)
In 19X0 and 19X1, most of the resources are applied to:

property, plant, and equipment.
b) The percentage of own and outside capital in 19X0 and 19X1 is:
Outside Capital
Own Capital
Total Liabilities & Net Worth
19X0
19X1
55%
45%
100%
45%
55%
100%
c) The share of own capital from 19X0 to 19X1 increased from 45% to 55% . This
shows that the increase in own resources was proportionally larger than the increase in
outside resources.
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PROGRESS CHECK 3.2

(Continued)
Jurure Company: Income Statement for 19X1

19X0
19X1
Net Sales
Cost of Goods Sold
SGA Expenses
3,000
1,280
480
100
43
16
5,100
2,460
1,071
100
48
21
Operating Profit
1,240
41
1,569
31
220
510
180
7
17
6
345
510
255
7
10
5
Earnings Before Tax
690
23
969
19
Income Tax
240
408
450
15
561
11
Depreciation
Financial Expense
+ Financial Income
Net Income
Question 4: Based on the vertical analysis of Jurure Companys income statement,

a)
In 19X1 , cost of goods sold ____________________ than net sales.

____ increased more slowly
____ decreased more slowly
____ increased faster
____ decreased faster
b) In 19X1 , operating profit decreased on a relative basis because net sales increased
________ than cost of goods sold.
____ faster
____ slower
c) In 19X1 , selling, general, and administrative ( SGA) expense ________ on a relative
basis.
____ increased
____ decreased
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Question 4: (Continued)
d) In 19X1, there was a(n) ______________ in financial expense in relation to net sales.
____ increase
____ decrease
e) Whenever expenses increase faster than income, profits _____________.

____ increase
____ decrease
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ANSWER KEY
Question 4: Based on the vertical analysis of Jurure Companys income statement,

a)
In 19X1 , cost of goods sold increased faster than net sales.
b) In 19X1 , operating profit decreased on a relative basis because net sales increased
slower than cost of goods sold.
c) In 19X1 , selling, general, and administrative ( SGA) expense increased on a relative
basis.
d) In 19X1 , there was a(n) decrease in financial expense in relation to net sales.
e) Whenever expenses increase faster than income, profits decrease .
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HORIZONTAL ANALYSIS
Purpose
Evaluate trends
over time
Horizontal analysis is a technique used to evaluate trends over time by

computing percentage increases or decreases relative to a base year. It
provides an analytical link between accounts calculated at different
dates using currency with different purchasing powers. In effect, this
analysis indexes the accounts and compares the evolution of these
over time.
As with the vertical analysis methodology, issues will surface that
need to be investigated and complemented with other financial
analysis techniques. The focus is to look for symptoms of problems
that can be diagnosed using additional techniques. Let's look at an
example.
Current Assets
Fixed Assets
Other Assets
TOTAL
19X0
19X1
*%
19X2
**%
$ 300
400
50
$ 450
600
100
50
50
100
$ 950
600
80
111
0
-20
$750
$1,150
53
$1,630
42
Percent change between 19X0 and 19X1
** Percent change between 19X1 and 19X2
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Technique
Comparing two
time periods
To compute the percentage of increase compared to the prior year, we

calculate the percentage growth for each account and subtract 100.
For example:
Current Assets 19X1
=
Current Assets 19X0
Total Assets 19X1
Total Assets 19X0
450
300
= 150% 100% = 50%
= 1,150
750
= 153% 100% = 53%
The analysis also works when account balances decrease. In these

situations, the growth rate will be negative as with "Other Assets" for
19X2. The computation for 19X2 is as follows:
Other Assets 19X2
Other Assets 19X1
Comparing
more than two
time periods
80
100
80% 100% = -20%
When a horizontal analysis involves more than two periods, the basis
may be defined as the preceding period for each successive period of
analysis, as in the above example 19X1 compared to 19X0; 19X2
compared to 19X1. Another possibility is to define the basis as the
growth in following periods measured against a designated base year,
as below both 19X1 and 19X2 compared to 19X0:
Current Assets
19X0
19X1
*%
19X2
**%
$300
$450
50
$950
217
Percent change between 19X0 and 19X1
** Percent change between 19X0 and 19X2
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Sales Growth
Key account
to analyze
Net sales is one of the most important individual accounts to be

analyzed by the horizontal methodology. It is a universal part of
financial analysis and often is the only account measured in terms of
percentage growth from one year to another.
The calculation of the sales growth rate is the same as the normal
horizontal technique. If we assume net sales of 1,000 in 19X0 and
of 1,200 in 19X1, the sales growth is:
Sales Growth =
Sales 19X1
Sales 19X0
1,200
1,000
= 120% 100% = 20%
Analyzing Net Sales Growth

Increased sales
vs. inflation
When we analyze the net sales growth figure, it is important to

determine how much of the increase is due to inflation and how much
is due to increased unit sales. An apparently strong sales increase
from one period to another could be entirely due to inflation. In fact,
volume sales could drop from one period to another, but increased
pricing could mask the drop as a reported sales increase in monetary
terms.
Increased sales
vs. competitors
You can also judge whether a company's sales are growing fast enough
by comparing them to the growth of sales for the industry as a whole.
If the real growth is eight percent for a certain sector, and
a firm within this sector experiences a volume sales growth of only
three percent, then this indicates a loss of market share. So, sales
growth helps measure the performance of a company over time and
also its performance relative to the performance of its competitors.
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Assumptions for
future growth
The sales growth rate is also very important for compiling projected
financial statements for a firm because it is the starting point for the
projection exercise. The sales growth assumption determines the
projected sales level which leads to other assumptions that determine
the rest of the income statement, then the current asset levels, and
finally, the rest of the balance sheet.
Please check your understanding of "Horizontal Analysis" by

completing the following Progress Check. You may then proceed to
Unit Four: Financial Ratios Liquidity.
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PROGRESS CHECK 3.3
material.
Question 5: Compute percentage increases and decreases in current assets for the
Cristina Company.
31 DEC 19X0
Cash
Trade Receivables
Inventories
Current Assets
31 DEC 19X1
$ 30
180
240
150
$ 600
$ 40
120
380
440
$ 980
%
___
___
___
___
___
a) Which account grew at the slowest rate? ____________________

b) Which account grew at the fastest rate? ____________________
Question 6: Compare the percentage growths in the income statement for Cristina
Company and answer the questions below.
31 DEC 19X0
31 DEC 19X1
Sales
Cost of Goods Sold
SGA Expenses
$ 1,400
900
200
$ 1,800
1,080
280
29
20
40
Operating Income
440
47
90
40
160
70
78
75
170
210
24
Income Tax
40
60
50
Net Income
130
150
15
Financial Expense
Other Expense
Earnings Before Tax
300
a) Which account had the lowest percentage growth? _______________

b) Which account had the highest percentage growth? _______________
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ANSWER KEY
Question 5: Compute percentage increases and decreases in current assets for the
Cristina Company.
31 DEC 19X0
Cash
Trade Receivables
Inventories
Current Assets
$ 30
180
240
150
$ 600
31 DEC 19X1
$ 40
120
380
440
$ 980
%
33
-33
58
193
63
a) Which account grew at the slowest rate? Marketable Securities a

b) Which account grew at the fastest rate? Inventories a
Question 6: Compare the percentage growths in the income statement for Cristina
Company and answer the questions below.
a) Which account had the lowest percentage growth? Net Income a
b) Which account had the highest percentage growth? Financial Expense a
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PROGRESS CHECK 3.3

(Continued)
Question 7: Based on the summary of accounts for Cristina Co. and the numbers in
Question 5, indicate whether the following statements are (T) true or (F)
false.
31 DEC 19X0
Current Assets
Sales
Net Income
$ 600
1,400
130
31 DEC 19X1
$ 980
1,800
150
%
63
29
15
____ a) Sales grew by 29%, jeopardizing both profit margins and liquidity.
____ b) Current assets grew faster than sales, mainly due to a build up of
inventories.
____ c) Net income grew less than sales because expenses grew faster.
Question 8: A strong net sales growth figure may be misleading if it primarily results
from:
____ a) increased inventory.
____ b) inflation.
____ c) increased sales volume.
____ d) reduced prices.
Question 9: An industry growth of ten percent compared to a firm's growth of four
percent indicates that the firm is:
____ a) losing market share.
____ b) gaining market share.
____ c) declining compared to the last period.
____ d) growing despite the competition.
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ANSWER KEY
Question 7: Based on the summary of accounts for Cristina Co. and the numbers in
Question 5, indicate whether the following statements are (T) true or (F)
false.
31 DEC 19X0
Current Assets
Sales
Net Income
$ 600
1,400
130
31 DEC 19X1
$ 980
1,800
150
%
63
29
15
a) Sales grew by 29%, jeopardizing both profit margins and liquidity.
b) Current assets grew faster than sales, mainly due to a build up of

inventories.
c) Net income grew less than sales because expenses grew faster.
Question 8: A strong net sales growth figure may be misleading if it primarily results
from:
b) inflation.
Question 9: An industry growth of ten percent compared to a firm's growth of four

percent indicates that the firm is:
a) losing market share.
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Unit 4
UNIT 4: FINANCIAL RATIOS LIQUIDITY
INTRODUCTION
An analyst uses financial ratios to understand the relationships among various financial
statement accounts. These ratios yield information about a companys ability to meet shortterm obligations on time, remain solvent over a long period, manage assets, and operate
efficiently.
In this unit, we demonstrate the calculation of two liquidity ratios: the current ratio and the
acid test (or quick asset) ratio. The current ratio tells us the amount of current assets that
are available to cover current liabilities. The acid test accomplishes the same purpose as the
current ratio, but it yields more precise information because it considers only the most
liquid assets. Finally, we will look at two situations that demonstrate how a companys
decisions can affect its liquidity ratios.
UNIT OBJECTIVES

n
Recognize the different types of financial ratios
Calculate a current ratio and an acid test (quick asset) ratio
Recognize how a companys decisions can affect its liquidity ratios
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FINANCIAL RATIOS LIQUIDITY
FINANCIAL RATIOS
Relationships
within accounts
The use of ratios and margins in financial analysis enables the analyst
to interpret the financial situation of an enterprise in a more
meaningful manner than by just looking at the absolute numbers.
Financial ratios consider the relationships that exist within various
accounts and, thus, facilitate an understanding of a companys financial
condition with greater depth and clarity.
Ratio analysis is another tool that helps identify changes in a
company's financial situation. A single ratio is not sufficient to
adequately judge the financial situation of the company. Several ratios
must be analyzed together and compared with prior-year ratios, or
even with other companies in the same industry. This comparative
aspect of ratio analysis is extremely important in financial analysis.
It is important to note that ratios are parameters and not precise or
absolute measurements. Thus, ratios must be interpreted cautiously
to avoid erroneous conclusions. The analyst should attempt to get
behind the numbers, place them in their proper perspective and, if
necessary, ask the right questions for further clarification.
Types of Financial Ratios

There are several types of ratios or relationships. They are categorized
as follows:
n
Liquidity ratios measure the ability of the enterprise to

meet its short-term financial obligations in a timely manner
Leverage ratios measure the solvency or viability of the

enterprise on a long-term basis
Turnover ratios measure how effectively the company's

assets are managed
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Profitability ratios measure the efficiency of operations

within the enterprise
We begin our discussion of financial ratios in this unit with liquidity

ratios. The remaining ratios are the subject of Units Five through
Seven. For future reference, you will find a Financial Ratio Summary
sheet at the end of Unit Seven. You may find it useful
as a quick reference as you work through these units.
LIQUIDITY RATIOS
Liquidity ratios measure the relationship of the more liquid assets

of an enterprise (the ones most easily convertible to cash) to current
liabilities. The most common liquidity ratios are:
n
Current ratio
Acid test (or quick asset) ratio
Current Ratio
Quantitative
relationship
between current
assets and
current
liabilities
The current ratio is frequently used to measure liquidity because it

is a quick and easy way to express the quantitative relationship
between current assets and current liabilities. It answers the
question: "How many dollars in current assets are there to cover
each $1.00 in current liabilities?" To calculate the current ratio,
divide current assets by current liabilities.
Current Ratio
Current Assets
Current Liabilities
A rule of thumb is that a current ratio close to 2.0 is good, but this is a
very generalized statement. Let's look at an example.
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COMPANY A
COMPANY B
Current Assets
Current Liabilities
$150
$100
$ 80
$110
COMPANY C
$400
$180
Current Ratio
1.50
0.73
2.22
Company C has $2.22 in current assets for each $1.00 in current debt.
It apparently has more liquidity and, therefore, appears to
be in a better position to pay its short-term debts than either Company
A or B.
Interpreting
the ratio
The current ratio must be interpreted with caution. An absolute

number by itself may not present a strong enough basis to draw
conclusions. The analyst must attempt to get behind the numbers and
verify that the current assets, which substantiate the ratio, are indeed
fully realizable. For example, if a relatively high current ratio index is
based on large amounts of trade receivables, the collectability
of these accounts should be investigated. If a large proportion of
receivables is delinquent, or if the current economic situation could
adversely affect timely collection efforts, then a high current ratio
will not necessarily indicate strong liquidity.
The same type of analysis should be made for inventories. When
excessive inventory levels on the balance sheet are the basis for a high
current ratio, the analyst should question whether obsolescence,
changes in style, physical deterioration, or changes in market prices
have affected the realization value of this inventory. When it seems
impossible to realize inventories in full, their value should be reduced
and the current ratio adjusted accordingly.
Testing
the ratio
It is advisable to test the strength of the current ratio by carefully

examining the enterprise's accounts receivable and inventory levels, or
by focusing on the turnover ratios discussed in Unit Six. This provides
a stronger feeling for the realization value of these two important
current assets.
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Another consideration is the average maturity dates for the current

assets and liabilities. If most of the current liabilities mature next
week, then significant amounts of trade receivables due in 60 days will
not provide the desired liquidity level. Since maturities of receivables
and payables seldom match, most companies are constantly dealing
with too little or too much liquidity.
The current ratio should, therefore, be used as a rough indicator
and never as an accurate statement of the company's actual
ability to pay.
Financing
patterns
The financing methodology normal to a sector can also have a

major impact on current ratio levels. This is part of what the analyst
considers in norms for specific sectors. For example, look at two
types of companies: a shoe producer and a supermarket chain.
Example:
Shoe producer
The shoe producer has major needs for inventory both raw
materials and finished goods because the nature of the business
is to produce many styles, sizes, and colors. In the real world, the shoe
company must also sell on a credit basis to entice shoe stores
to purchase its product. The business can, thus, be considered working
capital intensive. In such cases, a significant portion of the companys
own capital may be invested in financing working capital needs
since suppliers will not finance either finished goods or receivables.
The shoe producers probable current ratio is around 1.5, or maybe a
little higher.
Example:
Supermarket
chain
The supermarket sells on a cash basis and, therefore, does not have
a need to book receivables. The supermarket chain is also in a strong
position on purchasing and can often negotiate longer credit terms
than needed. The supermarket may take 60 day terms and turn over the
goods in 30 days, investing the funds for the other 30 days. The
supermarket chains probable current ratio is around 1.0, since there is
little or none of the supermarkets own capital invested in current
assets.
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Which of the two companies is more liquid? If you say the

supermarket, you are right because its products (mainly food) can
be sold more quickly than shoes. Yet its normal current ratio of
around 1.0 is much lower than the shoe producers 1.5. Be careful
about coming to quick conclusions about liquidity by looking solely at
the current ratio as a liquidity indicator. The analyst should also
consider financing patterns.
Acid Test
Considers most
liquid current
assets
The second commonly used liquidity ratio is the quick asset ratio,
often called the acid test. This ratio presents a more precise liquidity
test by considering only the more liquid current assets, thereby
excluding inventories, prepaid expenses, and other current assets from
the calculation. In this way, the index places greater emphasis on the
more immediate conversion of current assets to provide coverage of
short-term obligations. The rule of thumb for a healthy acid test index
is 1.0.
The calculation for this ratio is:
Acid Test
Cash + Near Cash Assets + Trade Receivables

Current Liabilities
The acid test presumes that trade receivables are more liquid than
inventories. Trade receivables are directly converted to cash;
inventories are first converted to trade receivables (if sales are
made on a credit basis) and then to cash. In addition, there is some
uncertainty of the value at which inventories will be realized, since
some items may become damaged, lost, or obsolete.
Two ratios are
complementary
Let's look at the current ratio example and see how the two ratios
complement each other.
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COMPANY A
COMPANY B
COMPANY C
Current Assets
Inventories
Current Liabilities
$150
$ 20
$100
$ 80
$ 30
$110
$400
$300
$180
Current Ratio
Acid Test
1.50
1.30
0.73
0.45
2.22
0.55
Company C has the highest current ratio, but it relies on realization of

inventories to cover its short-term liabilities. If it is unable to convert
the inventories to cash, it will only have $0.55 (400 300 180) in
quick assets to meet each $1.00 of current liabilities.
Company A probably has the best liquidity of all because it does
not depend on inventory realization to meet its debts. Even without
selling inventories, it has $1.30 in current assets to meet every
$1.00 in current debt.
Similar to the current ratio, the analyst must attempt to get behind the
acid test computed index and verify that the trade receivables
substantiating the ratio are fully realizable at the agreed upon term.
The analyst also must consider the firm's line of business since
companies that sell on a cash basis (such as supermarkets) have no
receivables on the balance sheet. The result is a very low quick asset
ratio even though the type of inventory sold (food, in the case of a
supermarket) may be very liquid. The company's liquidity situation
could be quite good despite a low acid test figure.
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Other Liquidity Indicators

Associated with
levels of cash
Besides the current ratio and acid test, there may be other liquidity
indicators. These could be associated with cash levels, such as:
n
Cash + Near Cash as % of Current Assets
Cash + Near Cash as % of Working Capital
Days Cash
The first two ratios are simple percentages. Days cash is a

comparison of cash to sales, with the resulting decimal figure
multiplied by the number of days in the period, 360 days for a yearly
calculation, to get the proportion of cash as of the balance sheet date
to the accumulated yearly sales figure.
The new Citibank spreadsheet includes days cash, along with days
receivable, days inventory, and days payable as liquidity ratios. This
recognizes that the turnover of these current assets is closely linked to
a companys liquidity position.
However, these balance sheet figures in terms of days of sales /
production have traditionally been considered turnover ratios, where
the analyst contrasts these balance sheet accounts with income
statement figures. We will consider these ratios later.
You have completed the sections on Current Ratio, Acid Test,
(quick asset ratio) and Other Liquidity Indicators. Please complete
the following Progress Check before continuing a further study of
liquidity ratios.
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PROGRESS CHECK 4.1
Directions: Enter the correct answers for the following questions. There is only one correct
answer unless otherwise stated in the question. Check your answers with the
Answer Key on the next page. If you answer any of the questions incorrectly,
return to the appropriate section of the text and review the material.
Question 1: Write the letter of the definition next to the type of financial ratios
it describes.
____ Liquidity ratios
____ Leverage ratios
____ Turnover ratios
____ Profitability ratios
a) Measures effectiveness of companys use of assets
b) Measures the efficiency of a companys operations
c) Measures the ability of a company to meet short-term obligations on time
d) Measures the ability of a company to remain viable over a long period
of time
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ANSWER KEY
Question 1: Write the letter of the definition next to the type of financial ratios
it describes.
c
Liquidity ratios
Leverage ratios
Turnover ratios
Profitability ratios
a) Measures effectiveness of companys use of assets

b) Measures the efficiency of a companys operations
c) Measures the ability of a company to meet short-term obligations on time
d) Measures the ability of a company to remain viable over a long period
of time
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PROGRESS CHECK 4.1

(Continued)
Question 2: Based on the following information, complete the statements below.

Cash
Trade Receivables
Inventories
625
1,920
2,360
Suppliers
Bank Loans
Accrued Taxes
460
350
90
Current Assets
4,905
Current Liabilities
900
a) By dividing current assets by current liabilities, we find a current ratio of _______.

We can say that the company has $ ____ in current assets to pay each $1.00 in
current liabilities.
b) This liquidity ratio is considered to be:
____ excellent.
____ good.
____ poor.
Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current
liabilities there is $1.45 in current assets.
a) The current ratio is ___________.
b) The ratio is considered to be:
strong.
adequate.
weak.
Question 4: The current ratio only gives a rough quantitative idea of the relationship
between current assets and current liabilities because it disregards the
different payment and collection times.
____ True
____ False
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ANSWER KEY
Question 2: Based on the following information, complete the statements below.
a)
Cash
Trade Receivables
Inventories
625
1,920
2,360
Suppliers
Bank Loans
Accrued Taxes
460
350
90
Current Assets
4,905
Current Liabilities
900
By dividing current assets by current liabilities, we find a current ratio of 5.45 . We

can say that the company has $5.45 in current assets to pay each $1.00 in current
liabilities.
b) This liquidity ratio is considered to be:

X
excellent.
good.
poor.
Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current
liabilities there is $1.45 in current assets.
a) The current ratio is 1.45.
b) The ratio is considered to be:
strong.
X
adequate.
weak.
Question 4: The current ratio only gives a rough quantitative idea of the relationship
between current assets and current liabilities because it disregards the
different payment and collection times.
X
True
False
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PROGRESS CHECK 4.1

(Continued)
Question 5: Look at the relevant portion of the balance sheet of TWR Company.
a)
Cash
Trade Receivables
Inventories
3,120
3,000
7,300
20,000
Suppliers
Loans
Accrued Taxes
Accrued Payroll
4,200
5,000
1,600
1,500
Current Assets
33,420
Current Liabilities
12,300
The current ratio is _____; the acid test is _____.
b) In both cases, the company will be able to pay its debts from current assets.
____ True
____ False
Question 6: Based on the following data, complete the statements below.

Current Assets
Current Liabilities
Inventories
Current Ratio
Acid Test
a)
Company B
Company C
10,600
6,500
4,700
5,100
3,800
400
1.63
0.91
1.34
1.24
Company ____ has a higher current ratio than Company ____.
b) The current ratio depends on the ability to sell inventories. If we exclude inventories
from current assets, liquidity falls to ____ for Company B and ____ for Company C.
c) The liquidity of Company C is more balanced since it does not depend so much on the
ability to sell inventories to meet current liabilities.
____ True
____ False
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ANSWER KEY
Question 5: Look at the relevant portion of the balance sheet of TWR Company.
a)
Cash
Trade Receivables
Inventories
3,120
3,000
7,300
20,000
Suppliers
Loans
Accrued Taxes
Accrued Payroll
4,200
5,000
1,600
1,500
Current Assets
33,420
Current Liabilities
12,300
The current ratio is 2.72 ; the acid test is 1.09 .
b) In both cases, the company will be able to pay its debts from current assets.
X
True
False
Question 6: Based on the following data, complete the statements below.
Current Assets
Current Liabilities
Inventories
Current Ratio
Acid Test
a)
Company B
Company C
10,600
6,500
4,700
5,100
3,800
400
1.63
0.91
1.34
1.24
Company B has a higher current ratio than Company C .
b) The current ratio depends on the ability to sell inventories. If we exclude inventories
from current assets, liquidity falls to 0.91 for Company B and 1.24 for Company
C.
c) The liquidity of Company C is more balanced since it does not depend so much on the
ability to sell inventories to meet current liabilities.
X
True
False
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PROGRESS CHECK 4.1

(Continued)
Question 7: Mark the following statements (T) true or (F) false.

____ a) Liquidity ratios are always accurate statements of whether or not a
company can meet its debts.
____ b) The higher a company's liquidity ratio, the less chance it has to pay
its debts.
____ c) Current ratio shows how many dollars in current assets a company
has to meet each $1.00 in current liabilities.
____ d) The acid test shows how many dollars the company has in quick
assets to cover each $1.00 in current liabilities.
____ e) The acid test ignores inventories because of the uncertainty of their value
until realized.
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ANSWER KEY

F
a) Liquidity ratios are always accurate statements of whether or not a

company can meet its debts.
b) The higher a company's liquidity ratio, the less chance it has to pay
its debts.
c) Current ratio shows how many dollars in current assets a company

has to meet each $1.00 in current liabilities.
d) The acid test shows how many dollars the company has in quick
assets to cover each $1.00 in current liabilities.
e) The acid test ignores inventories because of the uncertainty of their value
until realized.
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HOW LIQUIDITY RATIOS CHANGE

Example
There are many factors that can change a company's liquidity. Let's
look at the following example:
ASSETS
Current Assets
Fixed Assets
$3,000
2,000
Current Liabilities
Net Worth
$2,500
2,500
TOTAL
$5,000
TOTAL
$5,000
In this case, the company's current ratio is 1.20. Let's see how
different financial decisions can affect this current ratio.
Situation 1:
Short-term loan
The company takes a short-term loan of $800, increasing its current

liabilities. Let's see what happens if the company uses the proceeds to
(a) purchase inventories or (b) purchase equipment.
a) If the company purchases inventories, current assets will
increase and the balance sheet will look like this:
ASSETS
Current Assets
Fixed Assets
$3,800*
2,000
Current Liabilities
Net Worth
$3,300*
2,500
TOTAL
$5,800
TOTAL
$5,800
* An $800 increase over the starting point.
The current ratio for this balance sheet is 1.15.

Conclusion: If the current ratio is greater than 1.00, and
current assets increase while current liabilities increase by

the same amount, the current ratio decreases.
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b) If the proceeds of the loan are used to buy machinery, fixed

assets will increase.
ASSETS
Current Assets
Fixed Assets
$3,000
2,800*
Current Liabilities
Net Worth
$3,300*
2,500
TOTAL
$5,800
TOTAL
$5,800
The current ratio is now 0.91.

Conclusion: Using short-term loans (current liabilities) to buy
fixed assets causes liquidity to deteriorate.
Situation 2:
Increased
capital
The owners decide to increase capital by $800, thus increasing net

worth. The proceeds may be used to (a) add to inventories or (b) add to
machinery.
a) If the additional capital is used to purchase inventories, current
assets increase and current liabilities remain the same.
ASSETS
Current Assets
Fixed Assets
$3,800*
2,000
Current Liabilities
Net Worth
$2,500
3,300*
TOTAL
$5,800
TOTAL
$5,800
The current ratio is now 1.52.

Conclusion: Applying long-term resources (net worth) to
current assets improves liquidity.
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b) If the increase in capital is used to purchase machinery, fixed

assets increase while current assets and current liabilities
remain the same.
ASSETS
Current Assets
Fixed Assets
$3,000
2,800*
Current Liabilities
Net Worth
$2,500
3,300*
TOTAL
$5,800
TOTAL
$5,800
The liquidity ratio is 1.20.

Conclusion: Using long-term sources to finance long-term
uses does not affect the current ratio since the ratio only
measures current liquidity.
The examples demonstrate that the current ratio may vary according to
the situation. This ratio is only one source of information about a
company's financial status.
Please complete the following Progress Check before continuing to

Unit Five: Financial Ratios Leverage.
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PROGRESS CHECK 4.2

Directions: Select the correct answers for the following questions. There is only one correct
answer unless otherwise stated in the question. Check your answers with the Answer
Key on the next page. If you answer any of the questions incorrectly, return to the
appropriate section of the text and review the material.
Question 8: The following data reflect the situation of M&M, Inc. a few days before
balance sheet date.
ASSETS
Current Assets
Fixed Assets
TOTAL
$ 8,000
6,000
$14,000
Current Liabilities
Net Worth
$ 4,000
10,000
TOTAL
$14,000
The financial department of M&M is analyzing several proposals. The

department values liquidity highly and plans to recommend the proposal that
results in the best current ratio. Decide which proposal is the best by
calculating the resulting current ratios.
Proposal A
Before balance sheet date, take a short-term loan of $1,200 and

buy additional inventories.
Current ratio: ______
Proposal B

buy machinery and vehicles.
Proposal C
After balance sheet date, take the loan and buy inventories.
Which is the best proposal?
a) Proposal A
b) Proposal B
c) Proposal C
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ANSWER KEY
Question 8: The following data reflect the situation of M&M, Inc. a few days before
balance sheet date.
ASSETS
Current Assets
Fixed Assets
$ 8,000
6,000
TOTAL
$14,000
Current Liabilities
Net Worth
$ 4,000
10,000
TOTAL
$14,000
The financial department of M&M is analyzing several proposals. The

department values liquidity highly and plans to recommend the proposal that
results in the best current ratio. Decide which proposal is the best by
calculating the resulting current ratios.
Proposal A
Before balance sheet date, take a short-term loan of

$1,200 and buy additional inventories.
Current ratio:
Proposal B

buy machinery and vehicles.
Current ratio:
Proposal C
1.77
1.54
After balance sheet date, take the loan and buy inventories.
Current ratio:
2.00
Which is the best proposal?

a) Proposal A
b) Proposal B
X
c) Proposal C
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PROGRESS CHECK 4.2

(Continued)
Question 9: A few days before balance sheet date, Alpha Company and Beta Company
were in the following situations:
Alpha Company
Beta Company
Current Assets
$1,500
Current Liabilities 1,000
Current Assets $6,000

Current Liabilities
4,700
On the last day of the period:

+
Alpha took a short-term loan of $500 and purchased $500 in inventories.
Beta converted marketable securities of $2,000 into cash and repaid $2,000
in current loans, thus reducing both assets and liabilities.
Calculate the resulting current ratios:

Alpha
Beta
__________
________
b) Current ratio at balance sheet date:
__________
________
c) Company that made the best decision in

terms of improving liquidity:
__________
________
a)
Current ratio a few days before balance

sheet date:
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ANSWER KEY
Question 9: A few days before balance sheet date, Alpha Company and Beta Company
were in the following situations:
Alpha Company
Beta Company
Current Assets
$1,500
Current Liabilities 1,000
Current Assets $6,000

Current Liabilities
4,700
On the last day of the period:

+
Alpha took a short-term loan of $500 and purchased $500 in inventories.
Beta converted marketable securities of $2,000 into cash and repaid $2,000
in current loans, thus reducing both assets and liabilities.
Calculate the resulting current ratios:

a)
Current ratio a few days before balance

sheet date:
b) Current ratio at balance sheet date:

c) Company that made the best decision in
terms of improving liquidity:
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Alpha
Beta
1.50
1.28
1.33
1.48
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Unit 5
UNIT 5: FINANCIAL RATIOS LEVERAGE
INTRODUCTION
In general, leverage ratios focus on the sufficiency of assets, or generation from assets,
to cover the companys pending short- and long-term obligations. The liquidity ratios
discussed in Unit Four are similar in this regard but they are more concerned with the
urgency of coverage; leverage ratios are more concerned with overall volume of
coverage.
Leverage ratios, also called capital structure ratios or solvency ratios, measure the
relationship between outside capital and shareholder capital. Leverage ratios include:
n
Total indebtedness ratio, or leverage
Current and long-term indebtedness ratios
Fixed assets to net worth ratio
Interest or debt service coverage ratios
UNIT OBJECTIVES

n
Calculate a total indebtedness ratio
Recognize the significance of a companys leverage ratios
Identify generally appropriate leverage figures for different businesses
Calculate adjusted leverage
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FINANCIAL RATIOS LEVERAGE
TOTAL INDEBTEDNESS (LEVERAGE)
The total indebtedness ratio, often called leverage, is one of

the most important ratios for a banker. It is a good indicator of
company solvency (ability to pay all debts) and a general index
of the borrowers creditworthiness. From a bankers perspective, the
lower the ratio within an appropriate range, the better. A low ratio
indicates a greater asset coverage of liabilities and, therefore, a
greater cushion of capital to cover unforeseen difficulties. A
company with a low index denotes stronger capitalization which
can absorb greater risk.
Calculation
Standard
leverage
calculation
Outside capital is comprised of current and long-term liabilities that

represent resources loaned to the company by third parties. Own
capital is net worth. It represents the resources that stockholders have
invested and earned in the firm. We divide outside capital by own
capital to determine the total indebtedness of a company.
Outside Capital
Calculation:
Asset leverage
Own Capital
Total Liabilities / Total Net Worth
Another way of computing leverage is:

Total Assets / Total Net Worth
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This calculation emphasizes the concept of asset coverage for

payment of a companys liabilities. It is really a variation on the
standard or normal leverage, rather than a separate ratio. As you can
see in Table 5.1, the result of asset leverage always will be 1.0 more
than the result of standard leverage, so there is little to be gained by
computing both variations. Banks use one or the other the great
majority of banks use the standard leverage calculation.
Company A
Assets
Liabilities
Net Worth
Standard Leverage
Asset Leverage
Company B
Company C
1000
500
500
1000
600
400
1000
800
200
1.0
2.0
1.5
2.5
4.0
5.0
Table 5.1: Comparison of standard leverage and asset leverage
Leverage Analysis
Leverage should be analyzed within the context of the economic
sector of the borrower since the appropriate leverage figure may vary
from sector to sector.
Incidence of Fixed Assets
The amount of fixed assets on the balance sheet is one of the major
determinants of appropriate leverage. A heavy industry with major
fixed asset needs will require greater capital levels to sustain its
illiquid assets. The total debt for these types of companies will be
relatively low in comparison to net worth, resulting in relatively
low leverage levels. On the other hand, highly liquid companies
with little need for fixed assets (such as wholesalers or trading
companies) normally will operate at debt levels that are multiples
of net worth, resulting in leverage of two or three, or perhaps greater.
In Table 5.2, we show a comparison of the leverage for these two types
of companies.
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Heavy Industrial Co.
Trading Co.
Fixed assets
700
100
Total assets
1000
1000
Liabilities
400
800
Net worth
600
200
Leverage
0.67
4.0
Table 5.2: Leverage relative to the amount of fixed assets
Effect of Seasonality
The leverage figure should also be measured within the context

of seasonal borrowing patterns, if any, since these may distort the
analysis. For example, a food processing company may be forced to
take on debt at harvest time to enable payment to farmers. When the
processed goods are sold, the company can repay the loans.
Measuring leverage at the point of higher debt will result in a higher
figure than at other times during the year. So, the timing of the
balance sheet analysis should also be considered. In Table 5.3, you
can see how the leverage ratio for a company with seasonal
borrowing needs may vary for different periods during the year.
12/31
3/31
6/30
1000
800
1500
Liabilities
500
300
950
Net Worth
500
500
550
Leverage
1.0
0.6
1.7
Total Assets
Table 5.3: Leverage ratios for different periods
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Financial Leverage
Earlier, we said that from the lenders perspective, the lower the
leverage ratio for a company, the better. But, the borrowers interest,
in the case of capital sufficiency, may differ from the bankers. From
the shareholders point of view, if leverage is too low, profits may be
insufficient for the level of equity in the company, resulting in a poor
return on equity.
Borrowers
point of view
An obvious way to improve return on equity is to increase earnings.

Perhaps a less obvious way is to have less equity or net worth, which
means higher leverage. For this reason, from the borrowers point of
view, it may be more convenient to leverage up a business, within
reasonable parameters, in order to improve earnings per share. This is
the concept of financial leverage, which is illustrated in Table 5.4.
Reasonably
Conservative
Total Assets
Aggressively
Leveraged
Leveraged
1000
1000
1000
Liabilities
400
500
600
Net Worth
600
500
400
Earnings
100
100
100
0.67
16.7%
1.00
20.0%
1.50
25.0%
Leverage
Return on Equity
Table 5.4: Financial leverage borrowers perspective
Lenders
viewpoint
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From the lenders point of view, risk increases as liabilities

substitute for equity. Take the case of a heavy industrial company with
norms as listed in the first column of Table 5.4. If the company is well
run and has a strong position in its market, a lender may tolerate a
reasonable increase in leverage. However,
as the company leverages more aggressively, the banker will be less
tolerant from a risk perspective.
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Correct
leverage figure
The correct leverage figure for each company, then, may vary
considerably, depending on the liquidity of the assets, stability of the
economic sector, and factors within the market. But, it is safe
to say that the greater the amount of fixed assets, the greater the
capital needs and, therefore, the lower the normal leverage level.
In summary, the normal leverage ratios generally are as follows:
Information
resources
Heavy industries less than 1.0
Medium industries about 1.0 to 1.5
Retailers slightly higher, maybe at 2.0
Wholesalers slightly higher than retailers, perhaps 2.5

to 3.0 or higher
Financial services companies 10.0 times or greater,

sometimes as high as 20.0 (not to be confused with capital
adequacy which has its own rules regarding assets that do
not require capital backing).These companies tend to operate
with small amounts of fixed assets on their balance sheets
(generally less than 5% of total assets).
It is recommended that the analyst look up some figures within

his/her respective market to confirm these numbers, perhaps
business magazine listings of the top 100 companies in their
market. Industry averages, if available, are especially valuable for this
purpose. Whatever the source, it is important for the analyst to get a
feeling for the right figure for this important ratio to permit greater
depth in financial analysis and better judgment as to capital adequacy
among different types of borrowers.
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Tangible Net Worth

Net of
nonconvertible
assets
When analyzing a companys balance sheet, keep in mind that it may

show assets that are difficult or impossible to convert into
cash, such as pre-operating expenses or other intangibles, stale
receivables, obsolete inventories, etc. These assets should be
deducted from net worth for calculating leverage in order to present a
more realistic or conservative scenario. The result of
this write down is called tangible net worth.
Example
Lets look at an example for Company X:

Total assets
Current liabilities
Long-term liabilities
Net worth
$M
500
200
50
300
Utilizing stated net worth, the total indebtedness ratio is 0.83:

(200 + 50) / 300 = 0.83
However, Company X has some liquidity problems and $50,000 of its

assets cannot be converted into cash. If we calculate tangible net
worth, we see a different picture of the company:
(200 + 50) / (300 - 50) = 1.00
Utilizing tangible net worth (net of nonconvertible assets), we now get

an indebtedness ratio of 1.00. This means that outside capital
represents 100% of own capital.
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As we discussed in Unit One, standard financial analysis theory

recognizes that intangibles may not be convertible into cash and
eliminates these assets against net worth for calculating tangible net
worth. But this write down is not automatic. It should be done
only if the intangibles are determined to be of dubious value and
unrealizable. Other intangibles may be very valuable (examples:
licenses to produce international brands, goodwill resulting from a
recent privatization) and have a defined market value. In these cases, it
would not necessarily be appropriate to net these assets since they
may provide a major support to the net worth and value of the
company. It is up to the analyst to make this determination.
Revaluation Surplus
Result of
revaluing
fixed assets
Since a revaluation of fixed assets results in a corresponding increase

in revaluation surplus (a net worth account), net worth is increased by
the net amount of a revaluation. In many cases, this increase may be
justified by market conditions; but when the practice is unevenly
applied, it can also lend itself to manipulation of numbers.
Therefore, for purposes of calculating tangible net worth, it also may
be appropriate to write down the amount of revaluation surplus. This
is a judgment call for the analyst. At the very least, an analyst can
calculate leverage with and without revaluation surplus to highlight the
impact of revaluation on the leverage calculation as shown in Table
5.5.
Fixed assets
Total assets
Liabilities
Net worth
Computed leverage
Adjusted leverage
Before
After Revaluation
500
1,000
500
500
700
1,200
500
700
1.00
1.00
0.71
1.00
Table 5.5: Leverage with and without revaluation surplus
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Other Adjustments
Contingent
liabilities
Contingent liabilities, such as corporate guarantees, discounted

receivables with recourse, lease obligations, and open foreign
currency positions, should also be considered by the analyst when
studying a companys leverage position. If a certain event occurs,
a contingent liability may become direct (for example, a default
by the principal borrower where the company analyzed is a guarantor).
In Table 5.6, you can see that leverage increases if default occurs and
the guarantee becomes a liability.
Before
After Default
Liabilities
Net worth
500
500
700
500
Corporate guarantee
200
Leverage
1.0
1.4
Table 5.6: Increased leverage after default
Operating
leases
A similar situation may occur with operating leases where the

acquired assets are not booked on the user companys balance sheet.
By definition, the lease payments are expensed and there is no listed
liability. But, if we look at the case of an airline, we see that the
company cannot operate without the leased aircraft and lease
payments are really liabilities if the company plans to keep doing
business. Omitting these liabilities from the balance sheet distorts
reality, overstates the capital position, and severely understates the
generic leverage of the company.
Therefore, from the analysts point of view, it probably would be
prudent to include several years worth of lease obligations on the
balance sheet as a liability. How many years? This, again, is a
judgment call, but the Citibank Airlines and Aerospace Unit has used
up to seven years for this type of analysis. You can see the effect of
this leverage adjustment in Table 5.7.
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Total assets
Liabilities
Net worth
Unadjusted
Adjusted
1,000
600
400
2,400
2,000
400
Annual lease obligation

Average no. of years
200
7
Leverage
1.5
5.0
Table 5.7: Effect on leverage of liabilities adjusted for operating leases
In this situation, the shift to adjusted numbers results in major changes

in the perception of the capital sufficiency of the company.
Consolidations and Minority Interest
Consolidated
financial
statements
Consolidated financial statements present the accounts of a group of

interrelated companies as if they constitute only one company. With
this overview, the analyst can assess the financial position and
prospects of the entire group.
In the case of consolidated numbers, the auditor lists assets on the left
side, and liabilities, minority interest, and net worth accounts
on the right side of the balance sheet. But, what is minority interest? Is
it debt or equity? What should the analyst do with the minority interest
account in terms of analysis?
If you said that minority interest represents the portion of the
group of companies that is owned by minority shareholders, you
are correct. But, if this is ownership (i.e. net worth), why is the
account not included within the net worth section of the consolidated
balance sheet?
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The answer is that, by accounting conventions, consolidated figures

include all the assets under the control of the group, even those that
belong to third parties. The amount that the third party claims to
ownership is then segregated on the right side of the balance sheet
since it is not owned or controlled by the majority shareholders. The
stated net worth is the net worth of the controlling shareholders, to
whom the auditors report is addressed.
The analyst should be careful when considering these numbers
sometimes it appears from the presentation that minority interest is
a liability. But, it is not. What should be done with minority interest
for the purposes of calculating leverage? Answer: It should be
aggregated to net worth. Minority interest is, after all, legal equity.
This aggregation is precisely the methodology used in the new
Citibank spreadsheet. Incorrect and correct calculations of leverage
are compared in Table 5.8.
Incorrect
Total assets
Liabilities
Minority interest
Net worth
Leverage
Correct
1,000
500
100
400
1,000
500
100
400
1.50
1.00
Table 5.8: Aggregating minority interest with net worth to

calculate leverage
The total indebtedness ratio compares outside capital to own capital to

indicate a companys leverage position. From the lenders point of
view, low leverage indicates strong capitalization and less business
risk. From the borrowers point of view, it may be more convenient to
be more highly leveraged. The analyst must get behind the numbers
to understand the impact of the leverage figure on the perceived
business risk of a company.
In the next section, we discuss two ratios that separate short-term
liabilities from long-term liabilities to give a clearer picture of a
companys financial situation.
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CURRENT AND LONG-TERM INDEBTEDNESS RATIOS
The total indebtedness ratio shows the relationship of total

indebtedness to own capital. The current indebtedness ratio shows
the proportion of current indebtedness to own capital (net worth), and
the long-term indebtedness ratio shows the proportion of long-term
indebtedness to own capital. Added together, the figures should equal
the total indebtedness ratio.
Example
Lets look at an example that compares the indebtedness ratios

for two companies. Even though the total indebtedness ratio is
the same, the current and long-term ratios provide more in-depth
information about leverage for these companies.
Company A
Company B
Current liabilities
Total liabilities
100
100
200
180
20
200
Net worth
200
200
0.50
0.50
1.00
0.90
0.10
1.00
Current indebtedness ratio

Long-term indebtedness ratio
Total indebtedness ratio
Table 5.9: Indebtedness ratios for two companies
In Table 5.9, Company B may be in a less comfortable situation

because most of its indebtedness is short-term, while Company A has
at least one year to start paying 50% of its debts.
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A high current indebtedness ratio may be a cause for concern if

a large part of it is currently due for payment. Whether it is actually
a cause for concern or not will be dictated by the purpose of the
indebtedness. For example, if indebtedness is financing fixed assets, it
obviously is appropriate for this to be long-term financing. On the
other hand, if a trading company with practically no fixed assets is
financing receivables, it is appropriate for its entire debt to be shortterm. Here we see an overlap between leverage and liquidity concepts.
A higher long-term indebtedness ratio results in greater liquidity as
the amount of short-term obligations are reduced relative to total debt.
FIXED ASSETS COVERED BY OWN RESOURCES
Fixed assets covered by own resources is the ratio that measures the
relationship between fixed assets and net worth.
Calculation: Fixed Assets / Net Worth
Net worth represents a companys permanent capital and should be

used to support fixed investments. Any excess of net worth over fixed
assets is used to fund working capital. If net worth is lower than fixed
assets, the difference is funded by outside capital. Lets look at two
situations for Alpha Company.
SITUATION A
Percentage of
net worth funds
working capital
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Current assets
Fixed assets
200
300
Current liabilities
Net worth
150
350
TOTAL
500
TOTAL
500
There is a difference of 50 between net worth and fixed assets. Since

net worth is greater, the difference of 50 is used to fund working
capital. In other words, the proportion of fixed assets to own
resources is 86%, and the remaining 14% of net worth is used to fund
the companys working capital.
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Now, suppose Alpha Company purchases a new plant for 100 that is
funded by long-term loans. The new situation is:
SITUATION B
Current assets
funded by
outside capital
Current assets
Fixed assets
200
400
Current liabilities
Net Worth
150
100
350
TOTAL
600
TOTAL
600
Fixed assets increase from 300 to 400 and total long-term liabilities
increase by 100. Fixed assets are covered by 350 in net worth and by
50 in long-term debt. Since the entire net worth is used to cover fixed
assets, current assets are funded entirely by outside capital.
COVERAGE RATIOS
Coverage ratios indicate the amount of funds generated by operations

to cover interest expense, long-term indebtedness, and
the current portion of long-term debt.
Funds From Operations Interest Coverage

This calculation finds the coverage existing from gross operating cash
flow ( GOCF or FFO, funds from operations) to enable payment of
interest expenses.
Calculation: GOCF / Gross interest expense
Remember, GOCF is operating profit (net sales - cost of goods sold selling and administrative expenses) plus depreciation, amortization,
and other non-cash charges. Therefore, GOCF may be significant, in
some cases, despite poor earnings. Capital intensive companies that
generate a great deal of depreciation or amortizations may find these
amounts of greater importance than operating profit.
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High ratio
indicates ability
to cover interest
from operations
5-15
The higher the number for this ratio, the better, since it means greater
ease of payment of interest. A number lower than one indicates an
inability to pay out interest expense from operations, requiring nonoperating sources to cover interest needs. An over-leveraged firm will
find this ratio to be low, perhaps near one, leaving it vulnerable to an
increase in interest rates or an economic downturn. Companies that
over leveraged themselves on Wall Street in the 1980s, such as
Macys and Bloomingdales, paid a heavy price for this, requiring
Chapter 11 protection from creditors to survive.
Funds From Operations Long-Term Debt Coverage

This ratio is similar to the previous one, but includes payment of longterm debt as well:
Calculation: GOCF / (Gross interest expense + Total LTD)
The number here will be greatly influenced by the amount of longterm debt, if any, on the balance sheet. It measures the coverage of
operational cash generation to contribute to interest and long-term
debt obligations. Since it does not take into consideration the payment
schedule of the long-term debt, this ratio is perhaps less useful than
the following ratio.
Debt Service Ratio

This ratio is similar to the previous two, but includes payment of the
current portion of long-term debt instead of total long-term debt:
Calculation: GOCF / (Gross interest expense + Current portion LTD)
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Here again, the higher the number for this ratio, the better, since
it means greater ease of debt service. A number lower than one
indicates an inability to pay out debt service from operations,
requiring reduction of working capital or non-operating sources
to cover interest needs. In such a case, the funding source will
probably be additional debt, if credit can be obtained. Again,
an over-leveraged firm will find this ratio to be low, leaving it
vulnerable to an increase in interest rates or an economic downturn.
This is precisely the risk of higher leverage for any company.
Summary
Leverage ratios measure the relationship between outside capital and
own capital. They focus on the sufficiency of assets to cover shortand long-term obligations.
Total indebtedness ratio (leverage) measures the relationship of
net worth to liabilities or assets.
Total liabilities / Total net worth
Total assets / Total net worth
The analyst may have to adjust the leverage figure for a company to
account for such factors as seasonality and liquidity of the assets.
From the lenders perspective, a lower ratio indicates lower risk.
Current and long-term indebtedness ratios show the relationship
between net worth and current or long-term debt.
Current liabilities / Total net worth
Long-term liabilities / Total net worth
Fixed assets covered by own resources measure the relationship

between fixed assets and net worth.
Fixed assets / Net worth
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Any excess of net worth over fixed assets is used to fund working
capital.
Coverage ratios measure the amount of funds generated from
operations to cover interest payments and the total or current portion
of long-term debt. The higher the number for these ratios, the greater
the ease of interest and long-term debt service.
Gross operating cash flow (GOCF) / Gross interest expense
GOCF / Gross interest expense + Total long-term debt
GOCF / Gross interest expense + Current portion of long-term debt
You have completed Unit Five: Financial Ratios Leverage. Please answer the questions
in Progress Check 5 to check your understanding of the material before proceeding to Unit
Six: Financial Ratios Turnover.
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PROGRESS CHECK 5
material.
Question 1: Based on the data supplied by Parker Company, complete the following
statements.
Current liabilities
Net worth
$100,000
$ 50,000
$200,000
a) The total indebtedness ratio is ________.

b) Outside capital represents _____ % of own capital.
Question 2: Check the statement(s) below that apply to Parker Company.

____ a) Most of the funds used by the company are provided by the owners.
____ b) There is $1 in own capital for each $0.75 in outside capital.
____ c) Indebtedness is high.
Question 3: From the borrowers point of view, the concept of financial leverage means:
____ a) lower leverage to reduce risk.
____ b) lower leverage to increase return on equity.
____ c) higher leverage to increase return on equity.
____ d) higher leverage to reduce risk.
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ANSWER KEY
Question 1: Based on the data supplied by Parker Company, complete the following
statements.
Current liabilities
Net worth
$100,000
$ 50,000
$200,000
a) The total indebtedness ratio is .75 .

b) Outside capital represents 75% of own capital.
Question 2: Check the statements below that apply to Parker Company.

a) Most of the funds used by the company are provided by the owners.
b) There is $1 in own capital for each $0.75 in outside capital.
Question 3: From the borrowers point of view, the concept of financial leverage means:
c) higher leverage to increase return on equity.
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PROGRESS CHECK 5
(Continued)
Question 4: Match the type of borrower with the general appropriate leverage figure.
a) 0.5 to 1.0
_____
wholesaler
b) 1.0 to 1.5
_____
heavy industry
c) 2.5 to 3.0
_____
financial services
d) 10.0 or >
_____
medium industry
Question 5: Company K and Company L make ceramic floor tiles. From the data supplied
below, complete the following statements.
Current assets
Fixed assets
Total assets
Current liabilities
Outside capital
Net worth
Total liabilities & Net worth
Company K
Company L
$ 898,000
1,291,000
$ 2,694,000
3,873,000
2,189,000
6,567,000
484,000
544,000
1,452,000
2,147,000
1,028,000
1,161,000
3,599,000
2,968,000
$ 2,189,000
$ 6,567,000
a) Total indebtedness ratio for Company K is ____.

b) Total indebtedness ratio for Company L is ____.
c) Company ____ has a stronger capital structure, because it has less outside
capital.
d) Both companies have a collection problem as $100,000 of assets cannot be
realized. Based on tangible net worth, the new total indebtedness ratios for
Company K and Company L are ____ and ____, respectively.
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ANSWER KEY
Question 4: Match the type of borrower with the general appropriate leverage figure.
a) 0.5 to 1.0
c Iwholesaler
b) 1.0 to 1.5
a i heavy industry
c) 2.5 to 3.0
d i
financial services
d) 10.0 or >
b i
medium industry
Question 5: Company K and Company L make ceramic floor tiles. From the data supplied
below, complete the following statements.
Current assets
Fixed assets
Total assets
Current liabilities
Outside capital
Net worth
Total liabilities & Net worth
Company K
Company L
$ 898,000
1,291,000
$ 2,694,000
3,873,000
2,189,000
6,567,000
484,000
544,000
1,452,000
2,147,000
1,028,000
1,161,000
3,599,000
2,968,000
$ 2,189,000
$ 6,567,000
a) Total indebtedness ratio for Company K is 0.89 .

b) Total indebtedness ratio for Company L is 1.21 .
c) Company K has a stronger capital structure, because it has less outside
capital.
d) Both companies have a collections problem as $100,000 of assets cannot be
realized. Based on tangible net worth, the new total indebtedness ratios for
Company K and Company L are 0.97 and 1.25 , respectively.
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PROGRESS CHECK 5
(Continued)
Question 6: Delta Company presents the following balance sheet.

Cash
Receivables
Inventory
Fixed assets
Intangibles
25
100
300
500
75
1,000
Leverage:
1.00

Payables
Accruals
Long-term debt
Net worth
200
150
50
100
500
1,000
In studying these numbers, the financial analyst finds out the following:
n
One week prior to the balance sheet closing, Delta discounted

receivables, with recourse, for 100.
There is an obsolete inventory of 50 on Deltas balance sheet.
Fixed assets recently were revalued by 100, following dubious practices.
Intangibles include deferred pre-operating expenses of 25.
Intangibles also include a valuable license recently bought for 50.
Delta is a guarantor of a weak companys short-term debt of 100.
Delta leases 200 in fixed assets not listed on the balance sheet, payable
in lease obligations over four years.
Calculate the appropriate adjusted leverage for Delta Company. Remember, every
adjustment to a balance sheet account has a corresponding counter entry, so you
should first adjust the entire balance sheet and then calculate leverage.
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Cash
Receivables
Inventory
Fixed assets
Intangibles
____
____
____
____
____
____
Adjusted Leverage:
____
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Payables
Accruals
Long-term debt
Net worth
____
____
____
____
____
____
5-24
ANSWER KEY
Question 6: Calculate the appropriate adjusted leverage for Delta Company. Remember,
every adjustment to a balance sheet account has a corresponding counter
entry, so you should first adjust the entire balance sheet and then calculate
leverage.
Cash
Receivables
Inventory
Fixed assets
Intangibles
Adjusted Leverage:
25
300
250
600
50
1,225

Payables
Accruals
Long-term debt
Net worth
450
150
50
250
325
1,225
2.77
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PROGRESS CHECK 5
(Continued)
Question 7: Use the data supplied by Gamma and Beta to complete the following
statements.
Gamma
Company
Current liabilities
Net worth
Beta
Company
$ 250,000
$ 50,000
$ 230,000
$ 158,000
$ 160,000
$ 241,000
a) The total indebtedness ratios for Gamma and Beta are ____ and ____, respectively.
b) The current indebtedness ratios for Gamma and Beta are ____ and ____, respectively.
c) _______ Company has the better capital structure because most of its liabilities are
long-term.
Question 8: Use the data supplied below to complete the following statements.
SITUATION A
SITUATION B
ASSETS
LIABILITIES
ASSETS
LIABILITIES
Current Assets
$350
Current Liabilities
$300
Current Assets
$350
Current Liabilities
$300
$100
Fixed Assets
$425
Net Worth
$475
Fixed Assets
$525
Net Worth
$475
TOTAL $775
TOTAL $775
TOTAL $875
TOTAL $875
a) Is working capital the same for both situations? ____ (Yes / No)
b) Situation ____ uses a portion of outside resources to cover fixed assets.
c) Situation ____ shows a portion of stockholders' resources funding working capital.
d) Situation A uses ____ % of own resources to fund fixed assets.
e) Situation A uses ____ % of own resources to fund current assets.
f) Situation B uses ____ % of own resources to fund fixed assets. The remainder of fixed
assets is funded by _____________ resources.
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ANSWER KEY
Question 7: Use the data supplied by Gamma and Beta to complete the following
statements.
Gamma
Company
Current liabilities
Net worth
a)
Beta
Company
$ 250,000
$ 50,000
$ 230,000
$ 158,000
$ 160,000
$ 241,000
The total indebtedness ratios for Gamma and Beta are 1.30 and 1.32 , respectively
b) The current indebtedness ratios for Gamma and Beta are 1.09 and 0.66 , respectively.
c)
Beta Company has the better capital structure because most of its liabilities are longterm.
Question 8: Use the data supplied below to complete the following statements.
SITUATION A
SITUATION B
ASSETS
LIABILITIES
ASSETS
LIABILITIES
Current Assets
$350
Current Liabilities
$300
Current Assets
$350
Current Liabilities
$300
$100
a)
Fixed Assets
$425
Net Worth
$475
Fixed Assets
$525
Net Worth
$475
TOTAL $775
TOTAL $775
TOTAL $875
TOTAL $875
Is working capital the same for both situations? Yes i
b) Situation B uses a portion of outside resources to cover fixed assets.

c) Situation A shows a portion of stockholders' resources funding working capital.
d) Situation A uses 89% of own resources to fund fixed assets.
e) Situation A uses 11% of own resources to fund current assets.
f)
Situation B uses 100% of own resources to fund fixed assets. The remainder of
fixed assets is funded by third party resources.
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PROGRESS CHECK 5
(Continued)
Question 9: The calculation for the funds from operations interest coverage ratio is:
____ a) GOCF / gross interest expense.
____ b) NOCF / net interest expense.
____ c) GOCF / net interest expense.
____ d) NOCF / gross interest expense.
Question 10: If the debt service ratio is less than one, which of the following may be
sources of repayment of the debt? (You may select more than one answer.)
____ a) Operations
____ b) Reduction in receivables
____ c) Reduction in inventory
____ d) Additional bank debt
Question 11: From the lenders point of view, which of the following is the best
combination?
____ a) High leverage and high coverage ratio
____ b) Low leverage and low coverage ratio
____ c) High leverage and low coverage ratio
____ d) Low leverage and high coverage ratio
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ANSWER KEY
Question 9: The calculation for the funds from operations interest coverage ratio is:
a) GOCF / gross interest expense.
Question 10: If the debt service ratio is less than one, which of the following may be
sources of repayment of the debt? (You may select more than one answer.)
b) Reduction in receivables
c) Reduction in inventory
d) Additional bank debt
Question 11: From the lenders point of view, which of the following is the best
combination?
d) Low leverage and high coverage ratio
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PROGRESS CHECK 5
(Continued)
Question 12: From the lenders point of view, which of the following is the worst
combination?
____ a) High leverage and high coverage ratio
____ b) Low leverage and low coverage ratio
____ c) High leverage and low coverage ratio
____ d) Low leverage and high coverage ratio
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ANSWER KEY
Question 12: From the lenders point of view, which of the following is the worst
combination?
c) High leverage and low coverage ratio
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Unit 6
UNIT 6: FINANCIAL RATIOS TURNOVER
INTRODUCTION
Liquidity ratios try to answer the question, What is the degree of coverage of liquid assets
for short-term obligations? Turnover ratios try to answer the question, How long does it
take the firm to realize receivables or inventories, or to pay its trade suppliers?
In this unit, we will see how turnover ratios complement liquidity ratios by informing
the analyst of the time it takes a company to convert trade receivables and inventory into
cash, or the amount of funds that has been provided by trade receivables. Correct reading of
the ratios, along with additional information about a companys business, may also help the
analyst to evaluate the quality of current assets. This determination is important in judging
liquidity, since current ratio coverage of liquid assets over short-term obligations
presupposes timely liquidation of receivables and inventory.
Some turnover ratios may be calculated in two ways: either as a straight turnover or
converted to days. The commonly used turnover ratios include:
n
Receivables turnover, or days receivable
Inventory turnover, or days inventory
Payables turnover, or days payable
Sales to assets turnover
Other turnover ratios may also be calculated, including days cash and securities or days
accruals, but the ratios listed above are the most common.
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FINANCIAL RATIOS TURNOVER
UNIT OBJECTIVES

n
Calculate the receivables turnover ratio (turnover periods in a year)
Calculate days receivable (average collection time)
Calculate the inventory turnover ratio (turnover periods in a year)
Calculate days inventory (amount of inventory on the balance sheet date relative
to the annual production)
Calculate the payables turnover ratio (turnover periods in a year)
Calculate days payable (average payment time)
Calculate the sales to asset turnover ratio
RECEIVABLES TURNOVER / DAYS RECEIVABLE
Receivables Turnover Ratio

Calculation
The receivables turnover ratio is calculated by dividing net credit

sales from the income statement by trade receivables from current
assets in the balance sheet.
Calculation:
Net Credit Sales / Trade Receivables
The sales figure should represent the entire year to prevent distortion
and to allow comparison to prior annual figures. For interim
calculations, the sales figure should be annualized, taking into account
any seasonal factors in the sales.
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Net credit sales

not itemized
in income
statement
Notice that the correct figure for sales is net credit sales, not total
net sales, because receivables, by definition, are sales made on a
credit basis. Sales made on a cash basis do not generate accounts
receivable. Yet, the Citibank spreadsheet calculates on the basis of net
sales (as is the case with the spreadsheet of most banks). If this
is technically incorrect, why do banks calculate this way? The reason
is that the income statement does not tell us what percentage of sales
is on a credit basis and what percentage is on a cash basis.
Use
approximate
percentages
Many companies that sell on credit terms do so for 100% of their

sales. In these cases, net credit sales and total net sales are the same.
If an analyst studies the financial statements of a company with
significant amounts of both credit and cash sales, he/she should find
out the approximate percentages and calculate an adjusted turnover.
Another point worth noting is the effect of value added taxes. If sales
taxes are included within the sales figure, then these must be netted
out as well.
Net out other

receivables
Note, also, that we use trade receivables for this calculation. This
means that other receivables, those not generated from normal trade
operations of the company, should be netted out to avoid distortion of
the numbers.
Examples
Lets look at the example of receivables turnover for two companies

in Table 6.1.
Net credit sales

Trade receivables
Turnover (times per year)
Company A
Company B
400
100
4.0
720
60
12.0
Table 6.1: Receivables turnover for two companies
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From these numbers, we can see that Company A turns over its trade
receivables four times per year while Company B turns over its trade
receivables twelve times per year. Therefore, Company B collects
much faster than Company A.
Days Receivable
Expresses
turnover in
terms of days
Most banks prefer to calculate days receivable, instead of receivable

turnover. Days receivable is another way of stating the same
information, but perhaps in more useful form. This methodology takes
the turnover number and expresses it in terms of the number of days in
a year.
Period of
one year
Taking the example in Table 6.1, a turnover of 4.0 means 90 days,

because 90 days is 1/4 of a year. A turnover of 12 times means 30
days, because 30 is 1/12 of a year. So days can be calculated by
dividing 360 by the turnover.
The following calculation is a more direct approach:
(Trade Receivables / Net Credit Sales) x 360
Period of less
than one year
If we are calculating turnover for a period of less than one year, we

substitute the appropriate number of days in the period for the 360.
For example, if the period is six months, we substitute 180 in the
formula.
In Table 6.2, you can see the calculation of days receivable for the
companies from Table 6.1.
Net credit sales

Trade receivables
Calculation
Days receivable
Company A
Company B
400
100
(100 / 400) x 360
90
720
60
(60 / 720) x 360
30
Table 6.2: Calculation of days receivable for two companies
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The figure for days receivable represents the collection period for
each company.
Collection
period relative
to credit terms
In studying the companies, the analyst should compare these numbers

to the average credit terms granted by the company. If Company A in
the example, grants credit terms of 90 days and Company B grants 30
days, then both are collecting well and probably have good quality
receivables on the balance sheet. However, if Company A grants terms
of 60 days, but is collecting
in 90 days, then we question the quality of the receivables
apparently there are significant amounts of past due accounts within
the balance sheet.
Average
receivables
for the year
Note that these calculations are based on year end numbers. Use
of average numbers for the year would be more precise, and would
provide the average collection period for the year. If we have monthly
balance sheets, we can obtain a more precise average receivables
figure during the year for this computation but an analyst rarely has
the luxury of monthly figures.
Seasonality
effect
We can calculate averages from quarterly figures, which is more

practical, or from beginning and ending year figures. This latter
calculation is not too helpful because it does not capture any
seasonality during the year. In practical terms, most banks,
including Citibank, simply use year-end figures for calculating days
receivable. The resulting figure can be affected by seasonal factors,
which, conceivably, can lead to a wrong interpretation of the result.
Example
Lets look at an example.

Omega Company produces clothing and sells to distributors on 90-day
terms. All sales are on a credit basis. Total annual sales are 12,000,
but sales in the October to December quarter constitute 40% of total
annual sales. These sales are spaced evenly per month, i.e. 1,600 in
October, 1,600 in November, and 1,600 in December.
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With this information, we know that accounts receivable at 12/31

should be entirely constituted by sales for the 90-day period between
October to December, i.e. 4,800. If we do a spreadsheet analysis of
the 12/31 balance sheet, what is the calculation for days receivable?
Calculation: (4800 / 12,000) x 360 = 144 days
In judging this number, the analyst can easily compare it to the

90-days credit terms and conclude there are problems with
collectibility of receivables. Wrong conclusion!
What we see here is the effect of seasonality. We have sales in this
quarter greater than the average sales per quarter for the year. The
sales total of 4,800 in the last quarter constitutes 4.8 months (144
days) of the total sales of the year, but they are collected in only 3.0
months. During other quarters, the sales are less than the average for
the year. In these other months, the days receivable calculation could
be 54 days (quarterly sales of 1,800), 72 days (quarterly sales of
2,400), or other numbers.
The analyst should recognize that the calculation of the days
receivable figures by the spreadsheet software could be misleading
and should interpret the numbers accordingly. In particular, the analyst
should understand whether the last quarter sales figures are average or
out of the ordinary.
Summary
Receivables turnover tells us how many turnover periods for
receivables a company has in one year. The calculation is:
Net Credit Sales / Trade Receivables
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A more direct approach is to calculate the number of days in one

collection period. The calculation is:
(Trade Receivables / Net Credit Sales) x 360
This figure is significant when compared to the credit terms granted by

a company. The analyst can draw some conclusions about the quality
of the receivables on the balance sheet and the companys ability to
collect them. Judgment should be based on calculations using average
numbers for the year, which give a more precise result than using yearend figures.
You have now completed the section on Receivables Turnover / Days Receivable. Please
complete Progress Check 6.1 before continuing on to the next section, Inventory Turnover
or Days Inventory.
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PROGRESS CHECK 6.1
Directions: Select the correct answers for the following questions. There is only one correct
answer unless otherwise stated in the question. Check your answers with the
Answer Key on the next page. If you answer any of the questions incorrectly,
return to the appropriate section of the text and review the material.
Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000
and net sales totaled $400,000. All sales are made on credit terms.
a) ABC Company's receivables turnover ratio is _____ times.
b) Their average collection time is ____ days.
Question 2: If the average collection time is 30 days, what is the turnover?

____ a) 8 times
____ b) 10 times
____ c) 12 times
____ d) 14 times
Question 3: The correct formula for calculating days receivable for one year numbers is:
____ a) (Total Net Sales / Total Receivables) x 360.
____ b) (Net Credit Sales / Trade Receivables) x 360.
____ c) (Trade Receivables / Total Net Sales) x 360.
____ d) (Trade Receivables / Net Credit Sales) x 360.
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ANSWER KEY
Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000
and net sales totaled $400,000. All sales are made on credit terms.
a) ABC Company's receivables turnover ratio is 8 times.
b) Their average collection time is 45 days.
Question 2: If the average collection time is 30 days, what is the turnover?

c) 12 times
Question 3: The correct formula for calculating days receivable for one year numbers is:
d) (Trade Receivables / Net Credit Sales) % 360.
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PROGRESS CHECK 6.1

(Continued)
Question 4: Kappa Companys annual sales are 240 million pesos, 75% of which are made
on credit terms of 60 days. The year end trade receivables are 30 million.
Calculate the days receivable.
Calculation:__________________
Days receivable:______________
Question 5: Gamma Companys annual sales are 480 million pesos, half of which are on
credit terms of 90 days. Sales are made evenly during the year and there are
no problems with past due accounts. Calculate the year end balance sheet
figure for trade receivables.
Calculation:___________________
Trade receivables:______________
Question 6: Based on the data from Company A, complete the following questions.
Company A
Cash
Trade Receivables
Inventories
2,600
1,500
8,200
13,000
Current Assets
25,300
Current Liabilities
11,000
Net Credit Sales
72,000
a) The current ratio is __________.

b) The acid test is __________.
c) The collections turnover is __________.
d) The average collection period is __________days.
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ANSWER KEY
Question 4: Kappa Companys annual sales are 240 million pesos, 75% of which are made
on credit terms of 60 days. The year end trade receivables are 30 million.
Calculate the days receivable.
Calculation: (30 / (240 % .75)) % 360
Days receivable:
60
Question 5: Gamma Companys annual sales are 480 million pesos, half of which are on
credit terms of 90 days. Sales are made evenly during the year and there are
no problems with past due accounts. Calculate the year end balance sheet
figure for trade receivables.
Calculation: (480 x .5) % (90/360) i
Trade receivables: 60 i
Question 6: Based on the data from Company A, complete the following questions.
Company A
Cash
Trade Receivables
Inventories
2,600
1,500
8,200
13,000
Current Assets
25,300
Current Liabilities
11,000
Net Credit Sales
72,000
a) The current ratio is 2.30 .

b) The acid test is 1.12 .
c) The collections turnover is 8.78 times.
d) The average collection period is 41 days.
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INVENTORY TURNOVER OR DAYS INVENTORY
Inventory Turnover
Number of
times
inventories are
replenished
The inventory turnover ratio indicates the number of times

inventories are replenished during the period. It is calculated by
dividing cost of goods sold (an income statement account) by
inventory (a current asset account).
Calculation: Cost of Goods Sold / Inventory
Notice that when we calculate receivables turnover we measure against

sales, whereas inventory turnover is calculated against cost
of sales. Why is this?
Receivables literally are sales made on a credit basis; they must be
booked at the sales price. But inventories have not been sold. By
accounting convention, these are carried on the balance sheet at
cost. Therefore, we calculate inventory turnover against cost.
Example
Lets look at an example.
Cost of goods sold

Inventory
Company X
Company Y
600
100
6.0
900
300
3.0
Table 6.3: Inventory turnover for two companies
From these numbers, we can see that Company X turns over its
inventory twice as fast as Company Y.
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The comments about average and year-end figures made in the

receivables discussion apply equally to inventory. Averaged monthly
figures are ideal, but the analyst rarely has this luxury quarterly
or semiannual figures may be more feasible. Yet, the Citibank
spreadsheet calculations are based on year-end figures only. Why?
It is simply more convenient to program it this way. If the analyst has
additional information (for example, quarterly figures) he/she can
make the calculation manually and compare it to the year-end
inventory figure.
Days Inventory
Inventory in
terms of days
Most banks prefer to calculate days inventory instead of inventory

turnover. Days inventory is another way of stating the same
information in a more useful format. This methodology takes the
turnover number and expresses it in terms of the number of days in
a year.
Taking the previous example, a turnover of 6.0 means 60 days, because
60 days is 1/6 of a year. A turnover of 3.0 times means 120 days,
because 120 is 1/3 of a year. So, days can be calculated by dividing
360 by the turnover.
As with receivables, there is a more direct approach.
(Inventory / Cost of Goods Sold) % 360
However, if were dealing with a period of less than one year, then we
For example, for six month figures, we substitute 180 in the formula.
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6-15
In Table 6.4, we calculate the days inventory for the same two
companies that we saw in the inventory turnover example.
Cost of goods sold

Inventory
Calculation
Days inventory
Company X
Company Y
600
100
(100 / 600) 360
60
900
300
(300 / 900) 360
120
Table 6.4: Days inventory for two companies
Length of time
company can
operate without
production
The figure for days inventory represents the amount of inventory

at the balance sheet cutoff date relative to annual production costs.
This indicates approximately how many days the company can operate
without additional production before closing its doors. For
a commercial company where the entire inventory is finished goods,
this approximate number may be close to reality as long as there
are no major seasonal effects. For an industrial company, this is a very
rough estimate because inventory is composed of both finished goods
and raw materials.
Consider type
of inventory
Actually, for an industrial company, the type of inventory should

be considered in the calculation of days inventory because the cost
element is different. Finished goods are valued at cost of goods sold
(raw material, labor, and overhead), but raw materials are valued at
purchase cost (or market, whichever is lower). This means that if
inventory is composed mostly of finished goods, the traditional
calculation can be quite accurate. If the inventories are essentially raw
materials (RM), the following calculation may be more appropriate:
(Raw Material Inventory / (Initial RM + Purchases - End RM)) % 360
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Where most of the inventories are raw materials, this is a more

accurate calculation. However, it is not the formula calculated by bank
spreadsheets because the income statement normally does not indicate
the amount of annual purchases of raw materials. If the analyst can
obtain this information, in some cases it may be useful
to make this extra calculation for a more precise evaluation of the
numbers.
Inventory
judging
appropriate
levels
In studying the numbers, the analyst likes to compare them to

something. The days receivable number is compared to credit
terms. What can days inventory be compared to? This is a difficult
question, but there are some factors to consider. The analyst must first
understand the business fundamentals to judge inventory sufficiency.
Type of
company
The type of company will determine the inventory an analyst should

consider. A shoe producer may have different styles, sizes, and colors
of products in stock, besides considerable amounts of raw materials. It
is a working capital intensive business. Commercial companies also
are inventory intensive, by nature, so these types of companies will
tend to have greater amounts of inventory on their balance sheets. On
the other hand, transport companies, and other service companies such
as hotels, have little need for inventory and will, therefore, have lower
levels on their balance sheet.
Selling
methodology
Selling methodology also has an impact. Does the firm sell on a

specific contract basis, or does it sell from stock? The first case may
involve little need for finished goods, while the second will have
greatly increased needs.
When considering the appropriate level of inventory, the analyst must
also take into account any potential seasonality. Clients that sell,
purchase, and produce the same amount every month are rare, so
inventory levels for most companies will vary from month to month or
quarter to quarter. The analyst should try to understand these seasonal
effects to more accurately interpret the days inventory figure at the
balance sheet date.
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There are no easy answers to enable precision in judging the

appropriate level of inventory for a company. The analyst should get a
feeling for what is appropriate from management and then look at
similar firms for comparison, remembering that no two firms are
exactly alike.
Generally,
less inventory
is better
We do know that within reasonable limits, from a financial perspective,

it is better to operate with less inventory. Why? Inventory has carrying
costs (space, control systems, pilferage, obsolescence, security,
insurance, etc.) and it also has financing costs either debt interest or
equity expectations. Therefore, holding inventory is an expensive
proposition; and that is why the theory of just in time inventory was
developed.
Reasons for
higher inventory
Some clients say they prefer to maintain higher inventory levels to

protect themselves against inflation, to get volume discounts on
purchases, or to nail down a lower exchange rate. All of these may be
true in specific cases, if the savings from lower prices at purchase
compensate for inventory carrying and financial costs. With the current
significantly reduced inflation levels and greater economic stability in
Latin America, these client comments are heard less and less.
Summary
The inventory turnover ratio calculates the number of times
inventories are replenished during the period. The calculation is:
Cost of Goods Sold / Inventory
Days inventory is another way of stating the same information, but

is the number most banks prefer to use. It expresses the turnover
number in terms of days in a year. The calculation is:
(Inventory / Cost of Goods Sold) % 360
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For periods of less than one year, the correct number of days is used
in place of 360.
In assessing the days inventory number, the analyst must consider the
following issues:
n
Type of inventory finished goods or raw materials
Appropriate level of inventory depends on type of company,

selling methodology, and seasonality
You have now completed the section on Inventory Turnover or Days Inventory. Please
complete Progress Check 6.2 before continuing on to the next section, Payables Turnover
or Days Payable.
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PROGRESS CHECK 6.2
material.
Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000,
the inventory turnover is _____ times and the inventory turnover time is
_____ days.
Question 8: Use the data below to complete the following questions.

Monthly Inventories 19X5
December, 19X4
January, 19X5
February
March
April
May
June
July
August
September
October
November
December
145,000
152,000
180,000
190,000
122,000
158,000
205,000
342,000
528,000
548,000
322,000
298,000
194,000
Cost of Goods Sold: $1,428,000

a)
Using average monthly inventories, we compute an inventory turnover of ____ times,

and an inventory turnover time of ____ days.
b) Using the average inventories of December 31, 19X4 and 19X5, we compute an
inventory turnover of ____ times, and an inventory turnover time of ____ days.
c) Using the ending inventory for December 31, 19X5 only, the figure for days inventory
indicating the days of stock in existence is ____ days.
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ANSWER KEY
Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000,
the inventory turnover is 4 times and the inventory turnover time is
90 days.
Question 8: Use the data below to complete the following questions.

Monthly Inventories 19X5
December, 19X4
January, 19X5
February
March
April
May
June
July
August
September
October
November
December
145,000
152,000
180,000
190,000
122,000
158,000
205,000
342,000
528,000
548,000
322,000
298,000
194,000
Cost of Goods Sold: $1,428,000

a) Using average monthly inventories for 19X5, we compute an inventory turnover
of
5.29 times, and an inventory turnover time of 68 days.
b) Using the average inventories of December 31, 19X4 and 19X5, we compute an
inventory turnover of 8.42 times, and an inventory turnover time of
43 days.
c) Using the ending inventory for December 31, 19X5 only, the figure for days
inventory indicating the days of stock in existence is 49 days.
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PROGRESS CHECK 6.2

(Continued)
Question 9: Gamma companys inventory is entirely made up of raw materials.

Movements for the year are as follows:
Initial raw materials:
Purchases:
Ending raw materials:
Cost of goods sold:
100
900
200
1,200
Using the most precise formula, calculate the days inventory at the balance
sheet date.
____ a) 72 days
____ b) 60 days
____ c) 80 days
____ d) 90 days
Question 10: Which type of company will tend to have the greatest inventory needs as
a percentage of total assets?
____ a) Hotel
____ b) Plastics producer
____ c) Department store
____ d) Mail courier
____ a) It is usually better for a company to have higher inventory levels.
____ b) The Citibank spreadsheet calculates days inventory based on
average inventory levels, taking beginning and year end figures.
____ c) Inventory turnover of 10 times is the same as 36 days.
____ d) The selling methodology of a company may affect appropriate
inventory levels.
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ANSWER KEY
Question 9: Gamma companys inventory is entirely made up of raw materials.

Movements for the year are as follows:
Initial raw materials:
Purchases:
Ending raw materials:
Cost of goods sold:
100
900
200
1,200
Using the most precise formula, calculate the days inventory at the balance
sheet date.
d) 90 days
Question 10: Which type of company will tend to have the greatest inventory needs as
a percentage of total assets?
c) Department store
F
a) It is usually better for a company to have higher inventory levels.
b) The Citibank spreadsheet calculates days inventory based on

average inventory levels, taking beginning and year end figures.
c) Inventory turnover of 10 times is the same as 36 days.
d) The selling methodology of a company may affect appropriate

inventory levels.
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PAYABLES TURNOVER OR DAYS PAYABLE
Payables Turnover
Measured
against
purchases
Payables turnover indicates the number of times that payables are rotated
during the period. It is best measured against purchases, since purchases
generate accounts payable.
Calculation: Total Purchases / Trade Payables
The purchases figure should represent the entire year, or the ratio will
be distorted and not comparable to prior annual figures. For interim
calculations, the purchases figure should, therefore, be annualized,
taking into account any seasonal factors in purchasing.
Example
Lets look at an example:
Total purchases
Trade payables
Company E
Company F
1,200
100
12.0
960
160
6.0
Table 6.5: Payables turnover for two companies
Company E has a higher rotation than Company F. This means that

Company Fs trade suppliers probably offer more generous credit
terms.
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Days Payable
Most banks prefer to calculate days payable, instead of payable
turnover. Days payable is another way of stating the same information in
a more useful form. This methodology takes the turnover number and
expresses it in terms of the number of days in a year.
In the previous example, a turnover of 12.0 means 30 days, because 30
days is 1/12 of a year. A turnover of 6.0 times means 60 days, because
60 is 1/6 of a year. So, days can be calculated by dividing 360 by the
turnover.
As with the other turnover ratios, there is a more direct approach.
(Trade Payables / Total Purchases) x 360
However, if we are dealing with a period of less than one year, we

For example, we substitute 180 in the formula for six month figures.
Lets calculate the days payable for the same two companies:
Company E
Total purchases
Trade payables
1,200
100
Calculation
Days payable
(100 / 1200) x 360

30
Company F
960
160
(160 / 960) x 360
60
Table 6.6: Days payable for two companies
Average
payment
period
The figure for days payable represents the average payment period
for the company. In studying the companies, the analyst would like to
compare these numbers to the average credit terms received by the
company.
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Common Variation
The days payable calculation is correct in theory, yet more often

(including the Citibank spreadsheet) we see the less precise
calculation for days payable:
Calculation: (Trade Payables / Cost of Goods Sold) x 360
Substitutes cost
of goods sold
The reason is that the figure for purchases normally is not specified in
the income statement, so we use the second best alternative as a
default. Notice that for a commercial firm this distinction is not
relevant. There is no processing of the goods and, therefore, the figure
for purchases is essentially the same as cost of goods sold.
For an industrial firm, there may be a significant difference. Lets look
at the same two companies, but this time we will include a figure for
cost of goods sold.
Cost of goods sold

Total purchases
Trade payables
Company E
Company F
1,800
1,200
100
1,200
960
160
Calculation #1
Days payable (purchase basis)
(100 / 1200) x 360

30
(160 / 960) x 360

60
Calculation #2
Days payable (cgs basis)
(100 / 1800) x 360

20
(160 / 1200) x 360

48
Variance from # 1
33%
20%
Table 6.7: Comparison of days payable calculation using purchases

as a basis vs. using cost of goods sold as a basis
Notice that these numbers are quite reasonable for industrial

companies. For Company E, purchases is 67% of CGS; for
Company F, the figure is 80%.
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Implicit error
using CGS basis
In the first case, the variance, or implicit error in calculating by

the CGS basis, is 33%, in the second case, it is 20%. The analyst,
therefore, must understand how the spreadsheet calculates and
recognize this implicit error when interpreting the spreadsheet
calculations. This applies to days payable for industrial companies or
for any other companies that have a significant amount of value added
to their products.
Seasonality
Similar to the situation with receivables, payables figures can be

significantly impacted by seasonality. Average payables figures are
useful but, as a practical matter, most banks (including Citibank)
simply use year-end figures for calculating days payable on the
spreadsheet.
Purchasing
frequency
varies
Many companies, especially retailers, purchase several times during

the year at specified intervals, instead of making equal purchases every
month. The resulting days receivable figure, therefore, can be affected
considerably by seasonal factors. Conceivably, this may lead to an
incorrect interpretation of the result. Lets look at an example.
Example
Theta Company sells clothing to the general public. All purchases

are on a credit basis, with average terms of 60 days. Total annual
purchases are 1,000, but purchases in November and December
together constitute 30% of this total.
With this information, accounts payable at 12/31 should be
constituted by the November and December purchases, i.e. 300.
If we do a spreadsheet analysis of the 12/31 balance sheet, what
is the calculation for days payable?
Calculation: (300 / 1000) x 360 = 108 days
In judging this number, the analyst can easily compare it to the credit
terms of 60 days and conclude that there are problems with payment
of receivables. Wrong conclusion!
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What we see here is the effect of seasonality. The purchase total of

300 in the last quarter constitutes 3.6 months (108 days) of the total
purchases of the year, but these are made in only 2.0 months. In other
words, we have purchases in November and December greater than the
average purchases for any other two months of the year. During other
two month periods, the purchases are less than the average for the
year, and the days payable calculation may vary for example, 36
days (two month purchases of 100), 48 days (two month purchases of
133), etc.
Spreadsheet
calculations
may be
misleading
As with the receivables calculation, the analyst should be careful

because the calculation of the days payable figures by the spreadsheet
software may be misleading. The analyst must understand this effect
and interpret the numbers accordingly. In particular, the analyst should
understand whether the last months purchase figures are average or
out of the ordinary.
Interpreting the Number

Recognize
reasons behind
the numbers
The higher the days payable, the better from a funds flow point of view.
However, if the numbers for this ratio, adjusted for seasonality, are too
high, this may indicate delayed payments to suppliers, possibly due to
cash flow difficulties. This could indicate serious trouble in a very
short period of time. A very low number should also be analyzed to
determine why this usually cheaper source of funding is not being
maximized. Are suppliers cutting back on credit? If so, what is the
reason for this?
Shorthand
funds flow
analysis
The days payable number is often analyzed in tandem with days

receivable and days inventory for a shorthand funds flow analysis. This
very generalized analysis may be used to estimate the working capital
requirements for a company. Remember, this is very generalized
because, all of these funds flows may be measured against a different
base (i.e. receivables vs. sales, inventory vs.
cgs, payables vs. purchases) so that each of the days has a
different value.
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+ Days receivable
+ Days inventory
- Days payable
= Operational working capital
Summary
Payables turnover is the average number of payment periods in a year
and should be measured against purchases.
The calculation is:
(Total Purchases / Trade Payables)
Days payable is the average payment period for a company and may be
compared to credit terms to evaluate a companys payment of
receivables.
The most common calculation is:
(Trade Payables / Cost of Goods Sold) 360
A more accurate calculation is:

(Trade Payables / Total Purchases) 360
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PROGRESS CHECK 6.3
Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials
constitute 75% of cost of goods sold, and payables equal $1,600,000,
the more exact figure for payables turnover is _____ times and the
corresponding days payable is _____.
Question 13: The formula for calculating days payable for one year figures with the most
precision is:
____ a) (Trade Payables / Cost of Goods Sold) x 360.
____ b) (Trade Payables / Total Purchases) x 360.
____ c) (Cost of Goods Sold / Trade Payables) x 360.
____ d) (Total Purchases / Trade Payables) x 360.
Question 14: The formula for calculating days payable for one year figures used within the
Citibank spread sheet is:
____ a) (Trade Payables / Cost of Goods Sold) x 360.
____ b) (Trade Payables / Total Purchases) x 360.
____ c) (Cost of Goods Sold / Trade Payables) x 360.
____ d) (Total Purchases / Trade Payables) x 360.
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ANSWER KEY
Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials
constitute 75% of cost of goods sold, and payables equal $1,600,000, the
more exact figure for payables turnover is 4.5 times and the corresponding
days payable is 80 .
Question 13: The formula for calculating days payable for one year figures with the most
precision is:
b) (Trade Payables / Total Purchases) x 360.
Question 14: The formula for calculating days payable for one year figures used within the
Citibank spreadsheet is:
a) (Trade Payables / Cost of Goods Sold) x 360.
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PROGRESS CHECK 6.3

(Continued)
____ a) Payables turnover indicates the number of times payables are rotated
during the period.
____ b) Company M has payables turnover of 10 times and Company N has
payables turnover of 6 times. Company Ms trade suppliers probably offer
more generous credit terms.
____ c) Payables turnover of 12 times is the same as 24 days receivable.
____ d) The figure for days payable represents the average payment period
for a company.
Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days
from its suppliers, but the year-end balance sheet indicates 108 days payable.
What are possible explanations of this situation, in whole or in part?
____ a) The high value added content of Betas production results in an implicit
error when calculating on a cgs basis.
____ b) Seasonal purchases at the end of the year distort the calculated ratio.
____ c) Beta Company has just increased its credit terms to buyers.
____ d) Beta Company pays late.
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ANSWER KEY
T
a) Payables turnover indicates the number of times payables are rotated

during the period.
b) Company M has payables turnover of 10 times and Company N has

payables turnover of 6 times. Company Ms trade suppliers probably offer
more generous credit terms.
c) Payables turnover of 12 times is the same as 24 days receivable.
d) The figure for days payable represents the average payment period
for a company.
Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days
from its suppliers, but the year-end balance sheet indicates 108 days payable.
What are possible explanations of this situation, in whole or in part?
a) The high value added content of Betas production results in an
implicit error when calculating on a cgs basis.
b) Seasonal purchases at the end of the year distort the calculated ratio.
d) Beta Company pays late.
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SALES TO ASSETS TURNOVER RATIO

Efficiency of
asset utilization
The asset turnover ratio is a comparison of sales to total assets.

This ratio is used less frequently in financial analysis than the
other turnover ratios, but is nonetheless very useful. It provides
a shorthand indicator of the efficiency with which assets are being
utilized in the business.
Calculation: Total Net Sales / Total Assets
Spreadsheet
calculation
It is best calculated against average total assets but, here again,

spreadsheets usually make a trade-off by calculating against endof-period total assets. If there has been considerable growth in
assets during the year, or if the companys business is very seasonal,
resulting in major swings in asset totals during the year, then the
analyst should obtain some additional numbers to enable calculating
average figures.
Example
Lets look at an example:

Company J
Company K
400
320
600
720
1.25
0.83
Net sales
Total assets
Turnover (times)
Table 6.8: Use of assets to support sales
Company K sells more, but Company J is more efficient because it

needs less asset resources per $1.00 of sales.
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Interpreting the Ratio

The higher,
the better
Generally, the higher the asset turnover the better more sales are
achieved with a given amount of asset resources. Where the turnover
is higher, there is greater operational efficiency.
Compare with
similar firms
Companies probably experience relatively little fluctuation in this

ratio from year to year. It is often best to measure this ratio against
similar firms in the market for a comparison of how efficient
individual companies are in using available resources.
The indicator may vary considerably from sector to sector, depending
on certain factors such as whether the firm must offer credit, and how
much. Perhaps the most significant factor is, as in the case with
leverage, the incidence of fixed assets. Companies that need a great
deal of fixed assets will have low ratios, and vice versa. Fixed assets
will act as a drag on this ratio and, in many cases, the actual numbers
for this ratio will be similar to the leverage figure.
It should be noted that leased assets off the balance sheet will distort
the asset turnover ratio by reporting a higher turnover than a real
figure would indicate. Therefore, if significant amounts of such assets
are used by the company, the analyst should adjust the balance sheet by
including these assets and recalculating this ratio.
You have completed Unit Six: Financial Ratios Turnover. Please answer the questions
in Progress Check 6.4 to check your understanding of the material before proceeding to
Unit Seven: Financial Ratios Profitability.
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PROGRESS CHECK 6.4
material.
Question 17: The sales / average total assets ratio measures the:
____ a) number of days of sales.
____ b) amount of assets sold.
____ c) relative efficiency with which assets are utilized in a business.
____ d) growth in sales from one period to another.
Question 18: Calculate the asset turnover ratio for Companies Q and R.
Sales
Total Assets
Company Q
800
600
Company R
1200
1500
a) The ratio for Company Q is ____.

b) The ratio for Company R is ____.
c) Which company is more efficient in usage of its assets?_____
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ANSWER KEY
Question 17: The sales / average total assets ratio measures the:
c) relative efficiency with which assets are utilized in a business.
Question 18: Calculate the asset turnover ratio for Companies Q and R.
Sales
Total Assets
Company Q
800
600
Company R
1200
1500
a) The ratio for Company Q is 1.3 .

b) The ratio for Company R is 0.8 .
c) Which company is more efficient in usage of its assets?
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PROGRESS CHECK 6.4

(Continued)
Question 19: Of the following types of companies, which would tend to have the
highest (H) and the lowest (L) asset turnover?
____ Hotel
____ Medium industry
____ Trading company
Question 20: Which of the following would tend to increase the sales / total assets ratio?
____ a) Acquisition of new machinery
____ b) Price increase on products sold
____ c) Decrease in days inventory
____ d) Extend credit terms offered from 60 to 90 days
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ANSWER KEY
Question 19: Of the following types of companies, which would tend to have the highest
(H) and the lowest (L) asset turnover?
L
Hotel
Medium industry
Question 20: Which of the following would tend to increase the sales / total assets ratio?
b) Price increase on products sold
c) Decrease in days inventory
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PROGRESS CHECK 6.4

(Continued)
Question 21: Use the following data to calculate the information requested for Company C
and Company D.
Company C
Company D
21,000
2,000
46,000
71,000
18,000
1,000
53,000
78,000
Current Assets
140,000
150,000
Total Assets
300,000
400,000
84,000
40,000
82,000
35,000
485,000
462,000
569,000
540,000
Cash
Trade Receivables
Inventories
Current Liabilities
Trade Payables
Net Sales
Cost of Goods Sold
Fill in the blanks based on the above information:

Company C
Current Ratio
Acid Test
Receivables Turnover (Times)
Average Collection Times (Days)
Inventory Turnover (Times)
Average Inventory Turnover Period (Days)
Payables Turnover (CGS Basis)
Days Payable
Sales to Assets Turnover
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Company D
6-40
ANSWER KEY
Question 21: Use the following data to calculate the information requested for Company C
and Company D.
Company C
Company D
21,000
2,000
46,000
71,000
18,000
1,000
53,000
78,000
Current Assets
140,000
150,000
Total Assets
300,000
400,000
84,000
40,000
82,000
35,000
485,000
462,000
569,000
540,000
Cash
Trade Receivables
Inventories
Current Liabilities
Trade Payables
Net Sales
Cost of Goods Sold
Fill in the blanks based on the above information:
Current Ratio
Acid Test
Receivables Turnover (Times)
Average Collection Times (Days)
Inventory Turnover (Times)
Average Inventory Turnover Period (Days)
Payables Turnover (CGS Basis)
Days Payable
Sales to Assets Turnover
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Company C
Company D
1.67
1.83
.82
.88
10.5
10.7
34
34
6.5
6.9
55
52
11.6
15.4
31
23
1.6
1.4
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PROGRESS CHECK 6.4

(Continued)
____ a) Company C probably has a stronger liquidity position than Company D.
____ b) The difference between the frequency with which inventory is converted
into cash, shown by Company C and Company D, is not very large.
____ c) On the average, Companies C and D collect their receivables within
34 days. Consequently, their billing terms must be 34 days.
____ d) Company C makes better use of its assets.
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ANSWER KEY
F
a) Company C probably has a stronger liquidity position than Company D.
b) The difference between the frequency with which inventory is converted

into cash, shown by Company C and Company D, is not very large.
c) On the average, Companies C and D collect their receivables within

34 days. Consequently, their billing terms must be 34 days.
d) Company C makes better use of its assets.
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Unit 7
UNIT 7: FINANCIAL RATIOS PROFITABILITY
INTRODUCTION
Companies are in business for one purpose to make profits. If a company accumulates
considerable losses year after year, it will not stay in business for long. Profits are the
driving force of growth and are the main source for repaying loans, making new
investments, and providing an adequate return to owners so they retain their interest
and financial backing.
Profits are important for another reason they measure the relative success of a company
and can readily be compared to other companies and to the capital market. Therefore,
profits reflect (and profit ratios measure) the effectiveness and efficiency
of management. The common profitability ratios are:
n
Return on Sales
Return on Assets
Return on Equity
UNIT OBJECTIVES

n
Calculate the three profitability ratios: return on sales, return on assets,

and return on equity
Recognize the DuPont formula for calculating ROE
Calculate ROE using the DuPont formula
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FINANCIAL RATIOS PROFITABILITY
PROFITABILITY RATIOS
Return on Sales
Dollar profit per
$100 in sales
The return on sales ratio (profit on sales) measures how many

dollars of profit are made for every $100 in net sales. The figure is
a percentage and is calculated as:
Net Income
Return on Sales =
x 100
Net Sales
Let's compare the profits for Company A and Company B.

Company A
Company B
$ 20
$200
10.0%
$ 100
$4,000
2.5%
Net income
Net sales
Ratio
Table 7.1: Profit comparison
We can see that Company A earned $20 for every $200 in sales,
a profit of 10%. Profits earned by Company B were higher in
monetary terms; but at 2.5% of net sales, they were proportionally
lower than those earned by Company A. Therefore, Company A
generates more income on each $1.00 in sales than Company B. This
is an indication that Company A generates profits more efficiently.
More
conservative
calculation
A conservative way to evaluate sales profit is to exclude extraordinary

items from net income. For example, if Company A had extraordinary
income of $5 and we subtracted this amount from net income, the
profit on sales would decrease to 7.5%.
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Return on Assets
Relationship
between profits
and resources
invested
Return on assets is a good indicator of the productivity of the firm and

of management's abilities and efficiency. The index measures the
relationship between profits and total resources invested. It is a
percentage and is computed as:
Net Income
Return on Assets =
x 100
Average Assets
Since asset values vary during the year, the best measure is based on an
average of beginning-of-year assets and end-of-year assets. Let's look
at an example and compare the ratios calculated two ways.
End-of-year
assets
First, we calculate the return on assets based on end-of-year assets

only.
For 19X1, $ 150 / $ 6,000 = 2.5%
Average of
beginning and
ending assets
The more accurate method is to calculate return on assets based on the

average of beginning-of-year and end-of-year figures.
For 19X1, $ 150 / [($ 4,000 + $ 6,000) / 2] = 3.0%
However, as a practical matter, this ratio often is calculated based on

year-end figures only. This avoids calculating year one on a year-end
basis and subsequent years on an average basis, since averages cannot
be computed for year one. The Citibank spreadsheet calculates against
beginning totals.
For calculations utilizing interim figures, net income should be
annualized. In seasonal situations, this factor should be considered
in the annualization to avoid distortions in the full year net income
figure.
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The higher,
the better
Return on assets is best measured against prior period results from the
same firm or against similar enterprises. The higher the result, the
better, since a good return on assets indicates efficient use of the
firm's resources.
Return on Equity (Return on Capital)

Profits
generated by
each $1
invested
Return on equity ( ROE) measures the profits generated by each dollar

accumulated in the business by stockholders. The figure is
a percentage and is computed as:
Net Income
Return on Equity =
x 100
Average Net Worth
Return to
stockholders
Determining return on equity is important for measuring the degree to

which the profits of the firm provide a return to the shareholders. The
figure can be compared to a marginal investment rate in the
community, such as a time deposit rate in a local bank. ROE measures
whether the enterprise can produce an amount sufficient to cross this
hurdle rate and provide an incentive to take on additional risks of
equity investment.
If the ROE figure is very low in comparison to time deposit rates, the
owner is further ahead to liquidate the company's assets and deposit
the money in a bank. In these situations, the creditor should question
the owner's commitment to the firm, especially if the financial
situation deteriorates further.
Understand the
clients situation
In order to avoid some distortion in interpreting the figure, the

practical situation of the client should be understood. For example,
in a family enterprise, the analyst should consider (depending
on the market) that profits may be underestimated for tax purposes. In
these situations, the ROE figure is negatively impacted, and
comparison to other potential investments will be less valid.
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On the other hand, in situations where farms or valuable properties

have been held for many years and are undervalued on a balance sheet,
the net worth figure may be understated with reference to present land
values. In these situations, an adjusted return on equity figure may be
worse than what has been computed and what other market alternatives
provide.
Since the income was generated during the whole period, and
not just at the end, the average net worth should be used when
computing the figure. However, if prior period figures are not
available, ending period figures may be applied instead. For interim
figures, net income should be annualized. In seasonal situations,
this factor should be considered within the annualization to avoid
distortions in the net income figure.
Example
Let's look at the difference between using only the ending balance
and an average of the beginning and ending balance.
Net income
Stockholders equity
19X0
$
20
$2,000
19X1
$
60
$2,400
First method (using ending balance only):

For 19X1, $60 / $2,400 = 2.5%
Second method (using averages):

For 19X1, $60 / [($2,000* + $2,400*) / 2] = 2.73%
* Since the beginning value is $ 2,000 and the ending value $ 2,400, we may
presume that the owners' investment for the year averaged $ 2,200.
The Citibank spreadsheet calculates this ratio against beginning equity.

Assuming profitable operations, this results in a higher figure than
calculating an average equity.
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The appropriate level for return on capital is determined by relative

factors such as economic benchmarks, inflation, and local bank
deposit rates. Normally, the higher the ratio, the better the return on
capital. However, an abnormally high return-on-equity figure might
simply indicate deficiencies in the amount of capital within the firm.
Before proceeding to the final section of this unit, Integrated
Analysis, please check your understanding by completing Progress
Check 7.1.
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PROGRESS CHECK 7.1
material.
Question 1: Return on sales measures:

____ a) the percentage of items returned to the seller because of defects.
____ b) net sales divided by net income.
____ c) how many dollars of profit are made for every $100 of sales.
____ d) the effective use of invested resources.
Question 2: Please indicate whether each item is (T) true or (F) false. Return on
assets is:
____ a) calculated as Net Sales / Fixed Assets.
____ b) best calculated against asset averages.
____ c) good indicator of productivity of the firm.
____ d) not affected by seasonality.
Question 3: Select all that apply. A high return on equity for a firm may indicate:
____ a) undercapitalization of the firm.
____ b) that shareholders have made a good investment in the firm.
____ c) a need for liquidating the company.
____ d) that profits may be understated for tax purposes.
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ANSWER KEY
Question 1: Return on sales measures:

c) how many dollars of profit are made for every $100 of sales.
Question 2: Please indicate whether each item is (T) true or (F) false. Return on
assets is:
F
a) calculated as Net Sales / Fixed Assets.
b) best calculated against asset averages.
c) a good indicator of productivi ty of the firm.
d) not affected by seasonality.
Question 3: Select all that apply. A high return on equity for a firm may indicate:
a) undercapitalization of the firm.
b) that shareholders have made a good investment in the firm.
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PROGRESS CHECK 7.1

(Continued)
Question 4: Lets look at selected numbers from the financial statements of Companies S,
T, and U.
Net Sales
Average Assets
Average Net Worth
Net Income
Company S
1,000
1,500
900
Company T
1,000
800
400
200
120
Company U
1,000
400
100
40
Calculate the following ratios for each company:

Return on Sales
_____
_____
_____
Return on Asset
_____
_____
_____
Return on Equity
_____
_____
_____
Question 5: From the numbers in the previous question, answer each question by entering
the correct company.
____ a) Which company has the best investment return?
____ b) Which company makes the best use of its assets?
____ c) Which company has the best cost efficiency?
____ d) Which company has the overall best earnings?
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ANSWER KEY
Question 4: Lets look at selected numbers from the financial statements of Companies S,
T, and U.
Net Sales
Average Assets
Average Net Worth
Net Income
Company S
1,000
1,500
900
Company T
1,000
800
400
200
120
Company U
1,000
400
100
40
Calculate the following ratios for each company:

Return on Sales
4.0%
20.0%
12.0%
Return on Asset
10.0%
13.3%
15.0%
Return on Equity
40.0%
22.2%
30.0%
Question 5: From the numbers in the previous question, answer each question by entering
the correct company.
U
a) Which company has the best investment return?
b) Which company makes the best use of its assets?
c) Which company has the best cost efficiency?
d) Which company has the overall best earnings?
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INTEGRATED ANALYSIS
Integrate
financial ratio
concepts
Lets consider some theories used to integrate several of the main

concepts encountered in the units covering financial ratios. These
ideas also will tie together the profitability ratios we have just
considered. They are taken from financial relationships known as
a DuPont Analysis.
Return on Assets
We have seen that return on sales informs us of the profitability of
a companys operations how much it makes on every $1.00 of
sales. Lets take this a step further and consider this along with sales /
assets turnover. As formulas, we put the two together and see that by
multiplying, we obtain return on assets.
Asset
ROS
Net Income
Net Sales
Operational
leverage
Turnover
X
Net Sales
Total Assets
ROA
Net Income i
Total Assets
ROS can be considered cost efficiency, while asset turnover can be

considered a multiplier to achieve asset efficiency (which is ROA).
So, the higher the asset turnover, the greater the ROA. This is the
concept of operational leverage.

Note that asset turnover is increased either by increasing sales relative
to assets, or reducing assets relative to sales, or both. This is one
reason why it is better to operate with less assets less cash, less
receivables, less inventory, etc. This is also why it is so harmful to
have past due receivables, excessive levels of inventory, or nonproductive assets on the balance sheet. These act as a brake on asset
turnover and, hence, as a brake on ROA.
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Return on Equity
Lets take this another step. If we multiply return on assets by asset
leverage, we obtain return on equity.
Asset
Leverage
ROA
Net Income
Total Assets
Financial
leverage
Total Assets
Net Worth
ROE
Net Income
Net Worth
Here, again, we see that the beginning figure is multiplied by the next
column (in this case leverage) to obtain the final column, in this case
ROE. By multiplying ROA to obtain a figure for ROE, we can clearly
see how greater debt levels actually leverage earnings. This is the
concept of financial leverage.
From this formula, we can appreciate that greater leverage will achieve
greater earnings. This is correct as long as ROS is not adversely
affected by greater interest expense. Remember your vantage point.
The borrower uses this as an excuse to operate with greater debt
levels. The lender is more interested in reducing risk. If the investor
leverages up by taking on greater debt to finance capital expansion,
this may yield greater financial returns, but leave the firm vulnerable
to an economic downturn and/or higher interest rates.
The credit risk increases.
Application of DuPont Formulas

In total, the DuPont formulas can be summarized as follows:
ROS
Net Income X
Net Sales
Asset
Turnover
ROA
Net Sales = Net Income

;
Total Assets
Total Assets
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Asset
Leverage
ROE
X Total Assets =
Net Worth
Net Income
Net Worth
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Lets apply these concepts to some numbers to see if we can obtain an

idea of what is appropriate in terms of ROS, ROA, and ROE for
different companies through the DuPont insights. Consider the
following numbers for Companies X, Y, and Z.
Example
Company X
Company Y
Company Z
1000
1000
1000
1500
800
400
900
400
100
Net Sales
Average Assets
Average Net Worth
Net Income
180
Return on Sales
Return on Assets
Return on Equity
18.0%
12.0%
20.0%
80
8.0%
10.0%
20.0%
20
2.0%
5.0%
20.0%
Table 7.2: Profitability ratios for three companies
What insights can we get from these numbers using the DuPont
format? We have included the same numbers below. Remember,
the figure for asset leverage is 1.0 more than the standard debt / equity
leverage figure.
Net Income
Net Sales
Net Sales
Total Assets
Company X
18.0%
0.67
Company Y
8.0%
1.25
Company Z
2.0%
2.50
Net Income
Total Assets
X Total Assets
Net Worth
Net Income
Net Worth
12.0%;
1.67
20.0%
10.0%;
2.00
20.0%
5.0%;
4.00
20.0%
Company X
Why does Company X have the same ROE as Y and Z despite having the
highest ROS by a wide margin? Because it has low multipliers asset
turnover is low. Why is it low? The reason is probably due to the nature
of the company. It may be a heavy industry with heavy fixed asset needs
that operate as a brake on the ROE ratio. Leverage is also low (debt /
equity is 0.67), probably for the same reason.
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Lesson: We can see that heavy industries, or other companies with an

intensive use of fixed assets, need high margins to compensate for
poor multipliers.
Company Y
Company Ys multipliers are higher than Xs, but lower than Zs. Why?
It is probably a different type of company. With these numbers, it looks
like a medium industry, with asset turnover just greater than 1.0 and
leverage about the same (note: debt / equity = 1.00).
Lesson: The multipliers are better, so margins can be lower than
heavy industries to achieve the same ROE.
Company Z
Company Zs multipliers are very high, enabling an equal ROE despite

a very low margin. Why? It is probably a company with
low fixed asset needs and high liquidity of assets, permitting higher
leverage (equivalent debt / equity = 3.00). As such, there are probably
low barriers to entry in the business, which means it is probably a
highly competitive sector with low margins. It probably
is a wholesaler or trading company.
Lesson: Low margins can mean good profits overall if the asset and
leverage multipliers can be managed properly.
Conclusions
What is an
appropriate
ROS?
We have been able to draw some conclusions from this analysis in

terms of what is appropriate for ROS. If a company, by nature, has low
multipliers, ROS must be high to achieve an acceptable ROE. As
multipliers increase, ROS may be reduced, as well, and still achieve an
acceptable ROE.
Answer: The appropriate ROS depends on the multipliers.
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It should be obvious that companies do not willingly reduce their ROS;

this occurs as a result of competition. If Company Z can achieve a
ROS of 10% and maintain the same multipliers, its owners will be very
happy with its resulting ROE of 100%. This undoubtedly will attract
the attention of potential competitors, and eventually drive down the
ROS figure.
Appropriate
ROE
determined by
capital markets
From this viewpoint we also can appreciate that ROE sets the tone for
the other ratios. The appropriate figure for ROS depends on the
multipliers. The appropriate figure for ROA depends on the leverage
multiplier. What is appropriate for ROE? Capital markets determine
this, not multipliers. An acceptable ROE will be similar for all
companies in the market (higher for riskier sectors), regardless of
the multipliers. In the final analysis, the ROE figure will determine
which company has the best earnings.
Summary
In summary, integrated analysis helps us understand not only the
relationships between earnings ratios and operational and financial
leverage, but also provides insights into what is appropriate for return
on sales for different types of companies. This knowledge then
permits the analyst to obtain a deeper interpretation of the numbers,
and a better appreciation of what is appropriate, so that he/she may
judge the sufficiency of the numbers.
You have completed Unit Seven: Financial Ratios Profitability. Please answer the
questions in Progress Check 7.2 to check your understanding of these concepts. Following
the Progress Check is a summary chart of the financial ratios we have presented in this
workbook. Use it as a review for the final unit, Applied Financial Analysis Case Studies,
and also as a handy reference in the future.
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PROGRESS CHECK 7.2
material.
Question 6: Which of the following is the DuPont formula?

____ a) ROE
Leverage = ROS;
X Asset Turnover
____ b) ROA
Asset Turnover = ROS;
____ c) ROS
Leverage = ROA;
____ d) ROS
Asset Turnover = ROA;
= ROA
X Leverage
= ROE
X Asset Turnover
= ROE
X Leverage
= ROE
Question 7: Please indicate whether each item is (T) true or (F) false.
____ a) In the DuPont formula, asset turnover demonstrates the concept of
financial leverage.
____ b) In the DuPont formula, assets / net worth demonstrate the concept of
operational leverage.
____ c) ROS X Asset Turnover = ROA
____ d) High ROS is more important than high ROE.
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ANSWER KEY
Question 6: Which of the following is the DuPont formula?

d) ROS
Asset Turnover = ROA; X Leverage = ROE
Question 7: Please indicate whether each item is (T) true or (F) false.
F
a) In the DuPont formula, asset turnover demonstrates the concept of

financial leverage.
b) In the DuPont formula, assets / net worth demonstrate the concept of

operational leverage.
c) ROS X Asset Turnover = ROA
d) High ROS is more important than high ROE.
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PROGRESS CHECK 7.2

(Continued)
Question 8: Which type of company, by nature, should have the highest normal figure for
ROS?
____ a) Heavy industry
____ b) Retailer
____ c) Medium industry
____ d) Trading company
Question 9: Which of the following companies, by nature, should have the lowest normal
figure for ROS?
____ a) Heavy industry
____ b) Retailer
____ c) Medium industry
____ d) Trading company
Question 10: Company R has the following ratios. What is its ROE?
Return on Sales:
10%
Total Asset Turnover:
1.5
Debt / Equity:
1.5
Return on Equity:
______
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ANSWER KEY
Question 8: Which type of company, by nature, should have the highest normal figure for
ROS?
a) Heavy industry
Question 9: Which of the following companies, by nature, should have the lowest normal
figure for ROS?
d) Trading company
Question 10: Company R has the following ratios. What is its ROE?
Return on Sales:
10%
Total Asset Turnover:
1.5
Debt / Equity:
1.5
Return on Equity:
37.5%
SOLUTION:
ROS
10%
Asset
Turnover
1.5
ROA;
15%
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Leverage
2.5
ROE
37.5%
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The following chart is a summary of the financial ratios covered in the Financial Statement
Analysis Workbook. Please review the chart before continuing to Unit Eight: Applied
Financial Analysis Case Studies. Also, use it as a convenient reference in the future.
SUMMARY OF FINANCIAL RATIOS

RATIO
LIQUIDITY
Current
Acid Test
OPERATING
Days Receivables
FORMULA
EVALUATION
Current Assets
Current Liabilities
The higher, the better
Cash + Near Cash Assets + Trade Receivables

Current Liabilities
Average Trade Receivables x 360

Net Credit Sales
Days Inventory
Average Inventories
Cost of Goods Sold
Days Payables
Average Trade Payables

Total Purchases
Assets Turnover
Net Sales
I
Average Total Assets
The lower, the better,

generally
360
The lower, the better,

generally
x 360
The higher, the better,

generally
The higher, the better,
generally
LEVERAGE
Total Indebtedness
Total Liabilities
I
Tangible Net Worth
The lower, the better
COVERAGE
Interest Coverage
GOCF
I
Gross Interest Expense
Debt Service Ratio
GOCF
I
Gross Int Exp + Current Portion LTD
PROFITABILITY
Return on Sales
Net Income
Net Sales
x 100
Return on Assets
Net Income
I
Average Total Assets
x 100
Return on Equity
Net Income
I
Average Net Worth
x 100
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Unit 8
UNIT 8: APPLIED FINANCIAL ANALYSIS CASE STUDIES
INTRODUCTION
In earlier units, we looked at accounting issues, basic analysis concepts, and financial
statement analysis. In this unit, we will review this material and apply the analysis to case
studies, using a bank spreadsheet financial analysis model.
UNIT OBJECTIVES
When you complete this unit, you will:

n
Become familiar with a bank spreadsheet financial analysis model
Adapt client financial statements to the spreadsheet model
Discriminate the client numbers by making any adjustments necessary for the
financial analysis
Compute the ratios in the bank spreadsheet model
Compute key reconciliations for fixed assets and net worth
Interpret the results of the financial analysis
Project some key numbers to measure funds flows and needs
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APPLIED FINANCIAL ANALYSIS CASE STUDIES
THE BANK SPREADSHEET FINANCIAL ANALYSIS MODEL
Almost all banks utilize a standard form spreadsheet model for

financial analysis. The purpose is both to standardize and to simplify
financial analysis.
Different banks use different formats, although most of them are
similar in many ways. For conventional financial analysis of most
types of companies, Citibank utilizes a form (or variation of the form)
known internally as the OD-104. This form has been updated for
LAGF use, incorporating some new features such as monetary
correction, business risk assessment, and financial risk rating. For
financial analysis purposes, the OD-104 includes separate pages for:
n
Balance sheet
Income statement
Ratios
Certain account reconciliations
Funds flow analysis
Supplementary page, if needed, for more detailed breakdowns of

certain accounts
Aside from the OD-104, there are other formats for specialized or
non-conventional analysis. For example, analysis of banks and other
financial institutions is done on a spreadsheet that is appropriate for
bank financial statements.
Beginning with Unit Four of this course, we introduced many financial
ratios. The spreadsheet uses the most important of those ratios.
In certain cases, more detailed account information may be advisable
(for example, a breakdown of inventory or net fixed assets). The
supplementary data section allows the analyst to include this or other
appropriate information.
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The spreadsheet concept is applicable to both historical and projected

figures. Spreading of historical (actual) figures is crucial to financial
analysis, while projecting financial statements permits the analyst to
anticipate future funds needs and to measure the anticipated future
potential for cash generation.
Traditionally, bank spreadsheets have been a pencil, paper, and
calculator exercise. This can be tedious when spreading several years
of figures or putting together projections. Some banks still operate
this way but, with the recent advancements in microcomputers and
commercial spreadsheet programs, the exercise can be greatly
simplified. Use of these electronic microcomputer programs for
spreading and financial analysis also permits greater customization
and detail.
The sample spreadsheet which follows is the new OD-104 Citibank
format. You will see the balance sheet, income statement,
reconciliation for net worth and fixed assets, other reconciliations, the
funds flow statement, and a ratio section.
The remainder of this unit includes two case studies. By reading them,
and working through the practice exercises which follow,
you will be able to employ the concepts you learned in Units One
through Seven. The first case study in this unit Mindy Garment
Factory focuses on analysis of the balance sheet, income
statement, and financial ratios. The second case Tower Stores
focuses on reconciliations and the op / non-op statement.
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Company Name:
Country:
Amounts in 1= mill, 2 = thous, 3 = actuals:
Currency:
Local Curr enter 0, US$ enter 1:
Financials: Audited / Direct:
Qualified / Unqualified:
(Insert spreadsheet -- Balance Sheet)
Statements Purchasing Power Date:

Statement Date:
No. of Months in Period:
Audited
Unqualified
Annual Data
1/0/00
1/0/00
0
Audited
Unqualified
Audited
Unqualified
INTERIMS
0
Quarterly
1/0/00
1/0/00
0
1/0/00
1/0/00
0
BALANCE SHEET
Line #
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
ASSETS
Cash
Marketable Secs
Acct Receivables
Inventory
Other Receivables - non-operating
Other Current Assets - (operating)
Other Current Assets - (non-operating)
Total Current Assets
Net Fixed Assets
Investments in Subs & Affiliates
Other LT assets
Intangibles (inc. Goodwill)
Deferred Assets
Total Assets
LIABILITIES
Short-Term Debt
Current maturities of LT debt
Accts Payables - suppliers
Interest Bearing Payables
Income Taxes Payables
Other current liabilities - (operating)
Other current liabilities - (non-operating)
Total Current Liabilities
Long Term Senior Debt
Long Term Subordinated Debt
Capital Lease Obligations
LT Deferred Taxes / Reserves
Other LT Liabilities
28
Total Liabilities
29
Minority Interest
30
31
32
33
34
35
36
Preferred Stock
Common Stock
Capital Surplus
Reserves
Retained Earnings
Capital Revaluation
Other Capital Account
37
Total Net Worth
38
Total Liabilities + Min. Int. + N. Worth
39
***Balance Check Line
40
41
Pledged Assets
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8-5
INCOME STATEMENT
Pesos Thousands
Insert spreadsheet -- Income Statement
Annual Data
Quarterly
Statement Date:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
Pesos Thousands
Net Sales
Cost of Goods Sold (exclude Depreciation)
Selling & Admin Expenses (exclude Depreciation)
Operating Profit Bef Non-Cash Charges
Depreciation & Amortization
Operating Profit
Interest Income
Inflation income / (loss)
FX income / (loss)
Integral financing income / (loss)
Investment & Related Co income
Other non-oper non-cash income (Expense)
Other income / (Expenses)
Net Income bef Extraordinary Items
Extraordinary income (Loss)
Employee Profit Sharing
Minority interest
12
61
Income Tax
62
63
Net Income (Loss)

Dividends (input negative)
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
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Net Income bef income taxes
12
Change to Retained Earnings
NET WORTH RECONCILIATION

Opening Net Worth
Net Income
Dividends
Net Sale of Equity (inc. tr. stock)
Inflation adjustment
B/S adjustments against N. Worth
Other additions (checking account )
Ending Net Worth
FIXED ASSETS RECONCILIATION

Opening Net Fixed Assets
Depreciation
Net Revaluation against Net Worth
Net Revaluation / (w.o.) against I. Statement
Net Capital Expenditure (checking account )
- Maintenance Capital Expenditures
- Expansionary Capital Expenditures
- Gross Capital Expenditures
- Sale of assets (input negative)
Ending Net Fixed Assets
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RECONCILIATION STATEMENTS
Pesos Thousands
Statement Date:
Insert spreadsheet --Reconciliation Statements

128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
145
146
147
148
149
LT Debt Reconciliation (Senior + Subord. + cap. leas.)

Opening Long Term Debt (inc. curr.)
Foreign currency adjustment
Gain in debt repurchase (input negative)
Net change in debt (checking account )
- Gross new debt issued / contracted
- Repayments / Amortization (at book value)
Ending Long Term Debt
Inv. in Subs. & Aff. Reconciliation
Opening investments in Subs. & Aff.
Accrued Profits
Dividends received (input negative)
Extraordinary revaluation (against net worth)
Net Equity Contributions
Net purchase of new investments
- Gross purchases
- Sale of investments
Ending Investments in Subs. & Aff.
Inflation Adjustment / Monetary Correction Breakdown
Opening intangibles
Amortization (I/S line 28)
Net increase (additional payment for inv.)
Ending Intangibles
149
150
151
152
153
154
155
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
Intangibles Reconciliation (inc. Goodwill)

Marketable Secs
Acct Receivables
Inventory
Other Curr Assets - (non-operating)
Net Fixed Assets
Other LT assets
Intangibles
Deferred Assets
Short-Term Debt
Long Term Debt
Net Worth
Income Statement
171
172
Net Monetary Gain / (loss)

FX GAIN (LOSS)
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Insert spreadsheet -- Cash Flow
CASH FLOW
Pesos Thousands
Statement Date:
84
85
86
87
88
89
90
Pesos Thousands
Operating Profit
Other non-cash charges (Enter in section below)
Gross Operating Cash Flow (GOCF or FFO)
Changes in receivables
Change in inventories
Change in other current op.assets
90
91
Change in acc. & taxes payables

Change in other current op. liabilities
92
Net Operating Cash Flow (NOCF)
93
94
Maintenance Capital Expenditures

Free Operating Cash Flow (FOCF)
95
96
97
98
99
100
101
102
103
104
105
Net non-operating net income (net of non-cash)

Increase (Decrease) in Capital
Dividends from Subsidiaries & Affiliates
Sale of investments in Subs. & Affil.
Sale of fixed assets
Increase in S.T. Bk. & Financ. Debt
Increase in LT Bk. & Financ. Debt
Change in non-oper-non-fin curr Liabs.
Change in other LT liabilities
Change in Minority Interest
105
106
107
108
109
110
111
112
Growth of inv. in Subs., Aff. & Intangibles

Dividends Paid
Expansionary Capital Expenditures
Change in non-oper-non-fin curr assets
Change in other LT assets
Reduction in S.T. Bk. & Financ. Debt
Reduction in LT Bk. & Financ. Debt
Total Non-Operating Needs
112
Total Non-Operating Sources
Net Increase (Decrease) in Cash and Equivalents
112
CASH & EQUIV AT BEGINNING OF PERIOD
113
CASH & EQUIV END OF PERIOD
114
CASH & EQUIV AT END B/S
115
116
117
Unexplained Difference (CHECK)

Non-Cash Charges Breakdown
Total Other non-cash charges & B/S
118
119
120
Operational
121
122
123
124
125
126
127
Non Operational
FX loss / (gain)
Plus: Inf. Adjust. LT liabs. & N. worth
Less: Accrued profit related companies
Less: Other non-cash non-op income
Plus: Net change def. reserves
Less: Inf. Adjust. LT assets
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Allowance for Bad Debts

Inventory Write-off
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RATIO ANALYSIS
Annual Data
Quarter
Statement Date:
Insert spreadsheet
Ratio Analysis
No. of Months in -Period:
191
192
193
194
FINANCIAL HIGHLIGHTS (In US$ millions)

Total Assets
Net Worth
Tangible Net Worth
Working Capital
195
196
197
198
199
200
Net Sales
Operating Profit
Net Income
GOCF
NOCF
FOCF
201
202
203
204
OPERATING
Net Sales Growth (%)
Real Net Sales Growth (%)
COGS / Net Sales (%)
S.G. & Adm. Exp / Net Sales (%)
205
206
207
208
209
210
211
212
Op. Profit / Net Sales (%)

Net Income / Net Sales (%)
GOCF / Net Sales (%)
ROE - Net Income / opening Net Worth (%)
ROA - Net income / opening Total Assets (%)
Net Sales / Total Assets (%)
Dividend payout ratio
FOCF / Expansionary Capex + Dividends
LIQUIDITY
213
214
215
216
217
218
219
Current ratio
Quick assets ratio (1 + dec.)
Days receivables
Days inventory
Days payables
Cash & Secs (% of Total Assets)
Cash & Secs (Days Sales)
LEVERAGE
220
221
222
223
224
225
226
227
228
229
230
231
Total Liab / N. Worth + Min. Int. (Leverage)

Short Term Debt Concentration (max. 100%)
Funds from Operations Interest Coverage
Funds from Operations / Long Debt
Debt Serv. Ratio (FFO / Int. exp. + l.t. debt curr p.)
Tot. Gross debt (bk + oth Int. bearing) - Pesos thousands
- Short Term Debt - Pesos thousands
- Long Term Debt - Pesos thousands
Total Net Worth - Pesos thousands
Tangible Net Worth - Pesos thousands
Total Capitalization - Pesos thousands
Total Gross Debt to Capitalization
232
233
STOCK MARKET INDICATORS

Common shares (numbers in thousands)
Market Value - Pesos
234
235
P/E Ratio
Market / Book value
236
237
MACROECONOMIC INDICATORS
US$ value in Local Currency
Avg. US$ value
238
Inflation rate - for B.S. adj. - (%)
1.00
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1.00
0.00
0.00
1.00
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8-9
CASE STUDY:
MINDY GARMENT FACTORY
Introduction
The Mindy Garment Factory case involves an industrial company that requests a short-term
loan from a commercial bank to cover short-term operating needs. It is a new loan request
that must be analyzed by the bank's credit staff.
After reading the case study, you will be asked to perform a financial analysis of the
company as a practice exercise. The first step in the exercise is to examine the financial
statements submitted by the client, taking into consideration any additional verbal
information. Then, make any necessary adjustments to the client's numbers before including
them within the spreadsheet model. These adjustments, if any, pertain to the proper
presentation of the financial statements and those adjustments that are necessary for
calculating ratios. To do this, you must draw on basic accounting definitions and concepts
covered in Units One through Seven.
Once the adjustments have been made, you should compute the vertical analysis and
financial ratios included in the spreadsheet. To do this, you will draw on knowledge of
ratios and inter-account relationships covered in Units Four through Seven.
When the numbers have been laid out and the ratios computed, you will interpret the figures
to formulate financial conclusions and answer certain questions.
Keep these steps in mind as you read the case study.
Background
Yesterday, January 20, 19X4, the financial analyst of the Friendly Bank received the
financial statements of the Mindy Garment Factory for the fiscal years ending September
30, 19X1, 19X2, and 19X3. The numbers submitted by the client are attached. The manager
of the bank has asked his trusted analyst to immediately perform the financial analysis,
since the credit request is to be considered in today's afternoon session of the credit
committee.
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The company, which is not yet a client of the bank, requested a loan for Pesos 300,000
(exchange rate = Pesos 2/US$) for 180 days. The analyst has heard of the company, but has
never been directly involved with them in business transactions. The reason for the
expedited treatment of this credit is that the factory's owners are friendly with one of the
bank's directors.
The company has been established in the market for many years. It manufactures general
clothing (men's, women's, and children's) for the domestic market (growth rate of about 5%
annually), aimed at the middle and upper middle classes. The Mindy Garment Factory
principally has dealt with the Uptown Bank and with a specialized public sector bank for
long-term financing. It is owned by a respected and socially prominent local family that has
a reputation for being very conservative and traditional in its business dealings.
Conversation with the General Manager

Upon examining the financial statements, the analyst noted that the external auditor, the
firm of Siego, Zordo, & Mutho, was unfamiliar to him. The analyst had questions about
some of the numbers and called the general manager of Mindy for some clarifications. The
general manager has been with the company for fourteen years and was promoted to his
present position three years ago. Concerning the purpose of the loan, he said it was "for
working capital purposes."
With respect to sales, he indicated that Sales are growing following the same trends as
last year and that Our policy is to raise prices along with inflation, now estimated at 15%
per year by the analyst. We've never had problems with raising our prices due to the high
quality of our brand names and our entrenched market position, said the manager. We sell
85% of our production at 90 day terms to strong distributors. The other 15% is sold on a
cash basis through our own store, which is well located in the downtown shopping district.
The July - August - September quarter constitutes about 25% of annual sales and
production.
The analyst also asked why inventories were higher and payables lower in the past year. The
general manager said that, in the case of inventories, We wish to increase our stocks as a
hedge on inflation. Regarding payables, he said that Our policy is to buy some raw
materials on a cash basis to take advantage of discounts offered by some suppliers.
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Credit References
Before writing up his analysis, the analyst called an acquaintance at the Uptown Bank
a friend since university years. The Uptown banker indicated that the Mindy Factory had
been a client of Uptown for eight years. The present owners were the second generation of
the family to direct the company; they took over three years ago and installed the present
general manager.
The banker mentioned that, when the company was taken over with long-term notes by the
present generation of owners, a certain amount of goodwill was put on the company's
books. Also, about six months ago, the Mindy Factory sold an old warehouse for Pesos
210,000. Terms of the sale were three years, including 18 months grace.
The Uptown Bank, because of traditional relationships, mainly dealt with the owners rather
than the management; obligations were paid in a satisfactory manner, although rollovers
(renewals) were frequent on the short-term loan. Six months ago, Uptown Bank approved a
new credit facility, with full recourse to Mindy, of Pesos 400,000 for the discount of
receivables.
(A discount facility is one where the bank "buys" certain of the customer's trade
receivables at a specified price, for example, at a 10% discount. This means that the
customer receives $90 for every $100 of receivables. The bank collects the receivables
when they are due for payment of the amount advanced to the customer, plus interest.
Structuring with full recourse to Mindy means that Mindy guarantees payment of the
transaction in case the trade receivables are not paid when they are due.)
The credit facility was fully taken down almost immediately, and outstandings have not
changed since then. The Uptown Bank also has financed equipment purchases for Mindy
over the years, generally with good results. Uptown is now near its legal lending limit with
Mindy.
Financial Statements
The financial statements presented by the general manager of the Mindy Company follow.
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Financial Statements for Years Ending 9/30/X1, 9/30/X2, 9/30/X3
(Figures in Thousands of Pesos)
9/30/X1
9/30/X2
9/30/X3
BALANCE SHEET
Cash & Banks
Accounts Receivable
Inventory
Finished Goods
Work in Process
Raw Materials
85.7
1,012.2
102.7
1,267.6
121.6
993.7
369.4
34.0
648.2
1,051.6
623.2
44.6
658.2
1,326.0
1,056.2
49.0
702.4
1,807.6
Prepaid Expenses
Other Current Assets
Current Assets
42.5
33.8
2,225.8
46.0
28.4
2,770.7
52.4
245.6
3,220.9
Fixed Assets
Land
Buildings
Machinery & Equipment
Subtotal
Less: Accum. Depreciation
176.4
442.0
800.6
1,419.0
862.0
176.4
442.0
832.6
1,451.0
937.7
168.0
316.4
955.1
1,439.5
1,028.5
557.0
148.8
705.8
513.3
148.8
662.1
411.0
148.8
559.8
TOTAL ASSETS
2,931.6
3,432.8
3,780.7
Bank Debt, Short-term

Accounts Payable
Accruals
Other Current Liabilities
Current Liabilities
625.2
548.6
40.2
36.4
1,250.4
928.8
689.1
46.2
42.0
1,706.1
1,417.0
461.5
54.7
30.3
1,963.5
260.0
220.0
280.0
TOTAL LIABILITIES
1,510.4
1,926.1
2,243.5
Common Stock
Retained Earnings & Other
200.0
1,221.2
200.0
1,306.7
200.0
1,337.2
Owners Equity
1,421.2
1,506.7
1,537.2
LIABILITIES & OWNERS EQUITY
2,931.6
3,432.8
3,780.7
Net Fixed Assets

Goodwill
Non-current Assets
Long-term Debt
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9/30/X1
9/30/X2
9/30/X3
INCOME STATEMENT
Net Sales
Cost of Goods Sold
Selling, General, Admin. Expense
Operating Margin
Depreciation
Interest Expense
Earnings Before Taxes
Income Taxes
Net Income
Dividends Paid
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3,501.5
2,667.0
395.6
438.9
3,934.0
3,059.0
435.5
439.5
4,358.9
3,438.8
492.4
427.7
73.8
116.4
248.7
94.5
154.2
75.7
151.1
212.7
87.2
125.5
90.8
279.2
57.7
17.2
40.5
40.0
40.0
20.0
8-14
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EXERCISE 8.1
Directions: You are the financial analyst for Friendly Bank and you have been asked to
perform the financial analysis of the Mindy Garment Factory. This includes:
n
Analyzing the figures submitted by the potential client for conformity to

accounting conventions
Spreading the numbers onto the bank's own financial analysis form
Computing the ratios
Interpreting the figures
There are four parts to the exercise. Upon completion of each part, check your answers with
the Answer Keys which follow.
PART I
Refer to the client's financial statements and complete the Friendly Bank Financial Analysis
Spreadsheet Model that appears on the next two pages. Check your spreadsheet with the
suggestions for analysis and the spreadsheet solution that follow.
Step 1:
For purposes of analysis, make any necessary adjustments to the client's financial
statements either to achieve conformity to accounting conventions or for
purposes of financial analysis. There are three adjustments to be made; they
pertain to the correct levels for trade receivables, other current assets, and
tangible net worth.
Step 2:
Spread the numbers and calculate the percentages. Enter the figures, including
the adjusted figures, onto the partial spreadsheet format on the following two
pages. Ignore adjustments to the numbers for inflation.
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BALANCE SHEET
Line #
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
ASSETS
Cash
Marketable Secs
Acct Receivables
Inventory
(to be supplied)

Net Fixed Assets
Other LT assets
Deferred Assets
Total Assets
LIABILITIES
Short-Term Debt
28
Total Liabilities
29
Minority Interest
30
31
32
33
34
35
36
Preferred Stock
Common Stock
Capital Surplus
Reserves
Retained Earnings
Capital Revaluation
37
Total Net Worth
38
39
40
41
Pledged Assets
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INCOME STATEMENT
Pesos Thousands
Annual Data
Quarterly
Statement Date:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
Pesos Thousands
Net Sales
Operating Profit
Interest Income
FX income / (loss)
Minority interest
12
61
Income Tax
62
63
Net Income (Loss)

64
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ANSWER KEY
PART I
Suggestions for Analysis and Solution
Step 1:
For purposes of analysis, make any necessary adjustments to the client's

financial statements either to achieve conformity to accounting
conventions or for purposes of financial analysis. There are three adjustments
to be made which pertain to the correct levels for trade receivables, other
current assets, and tangible net worth.
Adjusting the Numbers (figures below in thousands)
The first task of financial analysis is to look at the numbers submitted by the client and
to make any necessary adjustments for purposes of analysis. This first step is important
to avoid computing inappropriate figures and indices, and to avoid making erroneous
conclusions based on incorrect ratios and data. The Mindy case offers three instances
where adjustments should be made to the statements submitted.
First Adjustment
In 19X3 Accounts Receivable:
Bank Debt, Short-term:
from 993.7 to 1,393.7

from 1,417.0 to 1,817.0
The first adjustment the most significant of the three refers to the level of
receivables in the third year, which seems to have declined considerably over levels of
the previous two years. This "reduction" in 19X3 could lead the analyst to conclude that
efforts to collect overdue receivables have met with some success in the last year.
However, for purposes of financial analysis, we should add back to receivables the 400
of the receivables discount line opened and taken down about six months ago, prior to
the balance sheet cutoff date. This is because the company is still liable for these
receivables. Management has probably taken its best receivables to the Uptown Bank and
discounted them to get these assets off its balance sheet. This strategy "improves" the
receivables situation, but the overall situation really is the same or worse since the
receivables left on the balance sheet are probably of inferior average quality.
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PART I: Step 1, Answer Key (Continued)
If we increase the asset receivables by 400, then we must also increase the liability side
of the balance sheet. The liability adjustment should be to short-term bank debt, as if
Uptown had made a straight loan instead of booking the facility as a discount line.
These adjustments will have a major impact on the computation of days receivable (see
below), and also on current ratio and leverage.
Second Adjustment
The second adjustment pertains to the sale of the warehouse, for Pesos 210, that
occurred six months ago, prior to the balance sheet cutoff date. This should be listed on
the balance sheet as non-current since terms of the sale included 18 months grace. This
means that no money will be received until 18 months from the time of sale.
Apparently, the sale amount has been included within other current assets, given the size
of the increase in this account for 9/30/X3. This is inappropriate and raises doubts about
the quality of the external auditor. The 9/30/X3 balance sheet should be adjusted to list
this asset as long-term receivables on the non-current asset section. This will have an
adverse impact on the current ratio for the year 19X3.
Third Adjustment
In 19X1, 2, 3 Goodwill:
from 148.8 to 0
Tangible Net Worth:
deduct 148.8 from N.W. each year
The third adjustment relates to the goodwill on Mindys books. This asset is an
intangible and should be reduced from the owners equity section in each of the three
years to compute the tangible net worth. This is because an intangible that is not
readily salable should not be included as part of the capital cushion for creditors.
Also, the item has been inappropriately booked. Goodwill resulting from the sale
of the company for more than book value should be registered on the books of the
acquiring company, not the company acquired. Leverage will then be adversely
impacted.
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PART I: Step 1, Answer Key (Continued)

Step 2:
Spread the numbers and calculate the percentages. Enter the figures, including
the adjusted figures, onto the partial spreadsheet format of the Friendly Bank
on the following two pages. Note that several boxes are blacked out.
BALANCE SHEET
Line #
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
9/30/X1
ASSETS
Cash
Marketable Secs
Acct Receivables
Inventory
9/30/X2
857.0

Net Fixed Assets
Other LT assets
Deferred Assets
Total Assets
LIABILITIES
Short-Term Debt
102.2
33.8
42.5
23.4
46.0
35.6
52.4
2,225.8
2,770.7
3,410.9
557.0
513.3
411.0
1,012.2
1,051.6
1,267.6
1,326.0
1,393.7
1,807.6
210.0
-
2,782.8
3,284.0
4,031.9
928.8
625.2
1,817.0
461.5
85.0
-
1,250.4
1,706.1
2,363.5
548.6
689.1
-
76.6

121.6
9/30/X3
88.2
280.0
260.0
-
220.0
-
28
Total Liabilities
1,510.4
1,926.1
2,643.5
29
Minority Interest
30
31
32
33
34
35
36
Preferred Stock
Common Stock
Capital Surplus
Reserves
Retained Earnings
Capital Revaluation
200.0
200.0
200.0
1,072.4
-
1,157.9
-
1,188.4
-
37
Total Net Worth
1,272.4
1,357.9
1,388.4
38
2,782.8
3,284.0
4,031.9
39
40
41
Pledged Assets
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INCOME STATEMENT
Pesos Thousands
Annual Data
Statement Date:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
Pesos Thousands
Net Sales
12
12
12
3,501.5
2,667.0
395.6
3,934.0
3,059.0
435.5
4,358.9
3,438.8
492.4
438.9
439.5
427.7
Operating Profit
90.8
336.9
212.7
248.7
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279.2
-
151.1
248.7

Minority interest
Net Income (Loss)

75.7
363.8
116.4

62
63
73.8
365.1
-
Income Tax
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61
64
9/30/X2
Interest Income
FX income / (loss)
Quarterly
9/30/X1
57.7
-
212.7
-
57.7
-
248.7
212.7
57.7
94.5
87.2
17.2
154.2
40.0
125.5
40.0
40.5
20.0
114.2
85.5
20.5
8-22
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EXERCISE 8.1
PART II
Based on the numbers from the preceding pages, compute the financial ratios for
19X1, 19X2, and 19X3. Do not calculate ratios for the blacked out boxes. Note that to
compute the days receivable number, you should remember that not all sales are made
on a credit basis.
RATIO ANALYSIS
Annual Data
Quarter
Statement Date:
191
192
193
194

Total Assets
Net Worth
Tangible Net Worth
Working Capital
195
196
197
198
199
200
Net Sales
Operating Profit
Net Income
GOCF
NOCF
FOCF
201
202
203
204
OPERATING
205
206
207
208
209
210
211
212

Dividend payout ratio*
LIQUIDITY
213
214
215
216
217
218
219
Current ratio
Days receivables
Days inventory
Days payables
LEVERAGE
220
221
222
223
224
225
226
227
228
229
230
231

Remember: Funds From Operating (FFO) is the same as Gross Operating Cash Flow (GOCF).
* Calculated: Dividends / Net Income
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ANSWER KEY
PART II
RATIO ANALYSIS
Annual Data
Statement Date:
191
192
193
194

Total Assets
Net Worth
Tangible Net Worth
Working Capital
195
196
197
198
199
200
Net Sales
Operating Profit
Net Income
GOCF
NOCF
FOCF
201
202
203
204
OPERATING
205
206
207
208
209
210
211
212

Dividend payout ratio*
Quarter
9/30/X1
9/30/X2
9/30/X3
12
12
12
2,782.8
3,284.0
4,031.9
1,272.4
975.4
1,357.9
1,064.6
1,388.4
1,047.4
3,501.5
365.1
154.2
228.0
3,934.0
363.8
125.5
201.2
4,358.9
336.9
40.5
131.3
76.2
11.3
10.4
4.4
6.5
12.4
(2.6)
77.8
11.1
10.8
(4.2)
78.9
11.3
125.8
25.9
9.3
3.2
5.1
9.9
4.5
119.8
31.9
7.7
0.9
3.0
3.0
1.2
108.1
49.4
1.78
0.88
122
142
74
3.1
9
1.62
0.80
136
156
81
3.1
9
1.44
0.64
135
189
48
3.0
10
1.19
1.42
1.90
1.96
0.88
1.33
0.91
0.47
0.47
885.2
625.2
260.0
1,148.8
928.8
220.0
2,097.0
1,817.0
280.0
1,272.4
200.0
4.43
1,357.9
200.0
5.74
1,388.4
200.0
10.49
LIQUIDITY
213
214
215
216
217
218
219
Current ratio
Days receivables
Days inventory
Days payables
LEVERAGE
220
221
222
223
224
225
226
227
228
229
230
231

Remember: Funds from Operations (FFO) is the same as Gross Operating Cash Flow (GOCF).
* Calculated: Dividends / Net Income
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EXERCISE 8.1
PART III
Interpret the results, focusing first on the income statement and then on the balance
sheet. In so doing, consider the percentage to sales as well as the ratios. Compare your
answers with the explanations on the following pages.
INCOME STATEMENT
Question 1: How do sales increases compare to inflation? What does this mean?
Question 2: Based on the numbers in the case, what do you think Mindy's pricing
policy situation might be?
Question 3: What do the numbers reveal about Mindy's operational efficiency?
Question 4: What effect are interest expenses having on profits?
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BALANCE SHEET
Question 5: What is the situation with receivables? What does it mean?

n
Remember that you adjusted the receivables amount.
Compare days receivable to credit terms offered.
Question 6: What is the inventory situation? What does it mean?

n
Calculate days of finished goods inventory.
Calculate days of raw materials inventory.
Contrast these numbers to the information provided by Mindy's

general manager.
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PART III (Continued)
Question 7: What is the situation with fixed assets? What does it mean?
n
Focus on accumulated depreciation.
What does this mean on the income statement?
Question 8: What is the situation with days payable?

n
Why decrease payables when the company has high working capital
needs?
Is Mindy really getting discounts for cash payment, or are trade

creditors cutting back?
Question 9: What can be said about the relationship between retained earnings and
capital of the firm?
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ANSWER KEY
PART III
Interpreting the Numbers
Interpretation of the numbers will be more meaningful if we consider some of the

comments made by the manager of the Mindy Factory. By listening for clues, we can
attempt to get behind the numbers and read between the lines. Let's start with the income
statement.
Income Statement
There is an obvious deterioration in the expense-to-sales relationships; each

year is producing less income on greater revenues. Several things, or more likely a
combination of several factors, could account for this.
Question 1: How do sales increases compare to inflation? What does this mean?
First of all, sales increases are lagging behind inflation despite the general
manager's assertion that price hikes are consistent with inflation. If what he
said is true, Mindy is selling less volume than in prior years. The company is,
therefore, losing market share since price increases account for the
monetary increases in sales. If this is not true, it indicates that the manager
has not been truthful or has insufficient control or understanding of his own
company.
In his favor, however, there could be some lag effect with rising prices and
inflation. On the other hand, if these can be passed on easily to the
company's buyers, as the manager asserts, then it should be factored into
pricing policies. Apparently, this has not been done.
Question 2: Based on the numbers in the case, what do you think Mindy's pricing policy
situation might be?
All of this could mean that pricing policies within Mindy are inadequate. Either
they have insufficient control of the company by not factoring all costs into
their price, or they have inadequate management information systems.
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PART III ANSWER KEY (Continued)

This could also indicate a highly competitive position within the industry that
does not permit passing off the higher cost. However, this would contradict
what the manager has said about being able to pass off increased costs
because of their strong brand names and entrenched market position.
Question 3: What do the numbers reveal about Mindy's operational efficiency?

Eroding margins could indicate less efficiency than the competition, but it is
difficult to know this until we compare industry averages. Eroding margins,
together with the breakdown on net fixed assets, could indicate increasing
maintenance costs on aging machinery and equipment (the plant apparently
is very old, given the high accumulated depreciation in relation to the booked
fixed assets) and a competitive atmosphere that won't permit passing off
increased costs to the consumer.
Question 4: What effect are interest expenses having on profits?

Sharply increasing interest expenses reflect increased debt levels necessary
to maintain increasing current asset levels. This, of course, results in reduced
profits. Significant dividends relative to earnings levels also act as a brake on
contributions to retained earnings, especially at a time when increased
capitalization is becoming more and more necessary.
Balance Sheet
The balance sheet reflects persistent deterioration, although it is not as obvious as on

the income statement. This deterioration is more pronounced after making the
adjustments in Part I of this exercise. The adjustments accentuate the decline in balance
sheet strength.
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Question 5: What is the situation with receivables? What does it mean?

For 9/30/X3, the computation for days receivables is:
Sales of
4,359 x .85
Receivables of 1,394 x 360

3,705
= 3,705
= 135 Days
This level is significantly and uncomfortably higher than sales terms of 90

days. It is virtually the same as the previous year (19X2 = 136 days), instead
of the apparent "improvement" from the reduced amounts of receivables on
the balance sheet which would have computed to 97 days.
Note, also, that the deviation from credit terms cannot be explained by
seasonality, since the July to September quarter comprises 25% of total
sales and production. In other words, the figures for the quarter should reflect
average numbers for the year.
This adjusted situation impacts heavily in terms of increased funds needs to
maintain the higher asset levels on the balance sheet, higher than if days
receivables were really 97 days. It also impacts profits negatively due to the
resulting heavier interest costs on the debt that are necessary to sustain the
larger assets. The worst part of this is that the situation probably indicates
significant amounts of uncollectible funds.
Question 6: What is the inventory situation? What does it mean?

Inventory levels have been steadily climbing, resulting in increased funds
needs and increasing interest costs. The most alarming aspect of this
situation is the growth in days of finished goods inventory, from 50 days in
19X1, to 73 days in 19X2, to 110 days in 19X3. This is alarming because of
Mindy's product, which is susceptible to style changes. The finished goods
build-up probably indicates stale merchandise that will require significant
sacrificing to clear the shelves.
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Raw materials inventories have maintained a slightly decreasing trend (87,
78, and 74 days) which could indicate stronger inventory management or tight
working capital that won't permit greater stocking. It is interesting to contrast this
with the general manager's assertion that Mindy was stocking up as a hedge on
inflation. Normally, this strategy would mean stocking up on raw materials which
are more in the nature of commodities. These are more price sensitive than
finished goods. Finished goods are also more sensitive to style changes, so
why would Mindy stock up on finished goods? That market is not fast-growing,
and Mindy appears to be losing market share.
Question 7: What is the situation with fixed assets? What does it mean?
From the high amount of accumulated depreciation in relation to the total
booked fixed assets (see the breakdown on the client financial statements),
we can see that net fixed assets are aging rapidly. This probably indicates
capital expenditure needs in the near future. The problem is, however, that at
present declining levels of profitability, the company won't be able to pay out
long-term debt, even at a long tenor. This situation also impacts costs due to
increased needs for maintenance expenditures.
Question 8: What is the situation with days payable?

Accounts payable show a disturbing trend (74, 81, and 48 days) from the
cash flow perspective. We don't know what credit terms to the company are;
but, at a time when current asset funding needs are increasing, this usually
cheaper source of funds should certainly not be decreasing. The general
manager says he's buying for cash to get discounts, but this sounds
improbable. More likely, some suppliers are either declining to sell on credit or
cutting back on credit terms.
Question 9: What can be said about the relationship between retained earnings and capital
of the firm?
On the equity side, it should be noted that capital is quite low in comparison
to retained earnings. This could be a risk since retained earnings can more
easily be taken out as dividends. Since the dividend policy has been
reasonably generous in the past, this could indicate a willingness to take out
more.
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EXERCISE 8.1
PART IV
Please answer the following five questions.

Question 1: Are the following conclusions about Mindy's present financial situation
probably (T) true or (F) false?
____ a) The company is losing market position.
____ b) Pricing policies are adequate.
____ c) Operations are becoming less efficient.
____ d) Current asset management is adequate.
____ e) The dividend payout ratio is too low.
Question 2: Select three reasons why the Mindy cash generation capacity is highly
suspect.
____ a) Very low profitability
____ b) Illiquid current assets
____ c) Low taxes
____ d) Improving margins
____ e) Declining trends
Question 3: The manager's stated purpose for requesting a loan is to increase working
capital. The more precise purpose of the loan probably is to:
____ a) finance fixed assets.
____ b) finance a new product line.
____ c) pay creditors.
____ d) hedge long-term liabilities.
PART IV (Continued)
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Question 4: Select three "clues" that indicate why the loan should not be granted.
____ a) Numbers sometimes contradict verbal information.
____ b) Owners are good friends of one of the bank directors.
____ c) There is a build up in potentially unrealizable current assets.
____ d) The company is a long-established business.
____ e) There are doubts regarding the manager's character and/or capacity
to do his job.
Question 5: What lessons can be learned from this exercise? Check the statements
that apply.
____ a) Numbers analysis, alone, is sufficient to make credit decisions.
____ b) Ratios are extremely useful, but there must be some discrimination of the
numbers that determine results before the ratios are computed.
____ c) Financial analysis should consider qualitative factors which permit more
meaning to be derived from otherwise sterile numbers.
____ d) Ratios never lie. Together, with the financial statements, they provide
absolute determinations about the condition of a company.
____ e) The analyst should develop abilities to "read between the lines" to frame
incisive questions that look for causes, not symptoms, and draw
appropriate conclusions.
____ f) It does not matter who the external auditor is because client financial
statements always comply with Generally Accepted Accounting
Principles.
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ANSWER KEY
PART IV
Question 1: Are the following conclusions about Mindy's present financial situation
probably (T) true or (F) false?
T
a) The company is losing market position.

Real sales growth (normal less inflation) is negative.
b) Pricing policies are adequate.

Pricing policies are inadequate, possibly due to:
Not enough management information
Inadequate cost accounting mechanisms
c) Operations are becoming less efficient.

Possible reasons include:
Inadequate cost systems
High maintenance costs on an old plant
The age and inefficiency of the plant
d) Current asset management is adequate.

We know that current asset management is inadequate because of:
Probable problems with uncollectible receivables
Probable stale finished goods inventory
Higher interest payments to sustain higher borrowing levels
Lower net income
e) The dividend payout ratio is too low.

The dividend payout ratio is too high, especially now when growth
of net worth is needed to build up capital, which raises doubts about
shareholder backing.
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PART IV ANSWER KEY (Continued)
Question 2: Select three reasons why the Mindy cash generation capacity is highly
suspect.
a) Very low profitability
b) Illiquid current assets
e) Declining trends
Question 3: The manager's stated purpose for requesting a loan is to increase "working
capital." The more precise purpose of the loan probably is to:
c) pay creditors.
The manager's stated purpose of "working capital" should never be accepted
by a banker. This imprecise answer could indicate that a manager does not
understand the real purpose for a loan, just that he needs money to keep the
company going. From our analysis, we can appreciate that the real purpose of
the loan probably is to pay creditors (suppliers or banks) who are pressing for
payment.
Question 4: Select three clues that indicate why the loan should not be granted.
a) Numbers sometimes contradict verbal information.
c) There is a build up in potentially unrealizable current assets.
e) There are doubts regarding the manager's character and/or capacity
to do his job.
In a couple of instances (market position, pricing, build up in finished goods
instead of raw materials as a hedge on inflation), the numbers contradict what
the general manager has indicated. This means that he is ignorant of the real
situation or that he is trying to deceive the banker to get the loan. This raises
questions about his competence and his ethics.
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PART IV ANSWER KEY (Continued)

The analyst can also assume that if the manager is not entirely forthright with
information before he receives the loan, there probably will be little cooperation
(should the loan be given) if there are problems with the credit. And, it is likely
that there will be immediate problems with the credit if the loan is made.
The timing of the loan request should also be noted since this business is
usually quite seasonal. January should be their best month for collecting from
their distributors after the Christmas sales. Requesting a loan now, in
January, is out of synchronization with their own business cycle.
The analyst's verdict, therefore, should be to deny the credit. Mindy is not yet
a client, and is not a desirable one either.
Question 5: What lessons can be learned from this exercise? Check the statements that
apply.
b) Ratios are extremely useful, but there must be some discrimination
of the numbers that determine results before the ratios are
computed.
c) Financial analysis should consider qualitative factors which permit
more meaning to be derived from otherwise sterile numbers.
e) The analyst should develop abilities to "read between the lines" to
frame incisive questions that look for causes, not symptoms, and
draw appropriate conclusions.
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CASE STUDY:
THE TOWER STORES
Introduction
In the Mindy case, you were introduced to the financial analysis spreadsheet model. You
looked at a customer's financial statements, made the necessary adjustments, included these
numbers within the model, and computed the ratios. This was done to perform a financial
analysis of the firm's historical figures and to decide whether or not a loan request should
be granted.
This case, Tower Stores, Inc., involves a commercial enterprise where the management
proposes a new sales strategy to promote greater growth and profits. The company requests
its bank's backing through an increase in short-term credit facilities. You, as the bank's
financial analyst, must measure the proposed strategies in light of historical trends to
project some key numbers. You will determine if the request should be accepted and,
if so, under what terms.
In this exercise, you will utilize the spreadsheet model not only to measure and analyze past
performance, but to project numbers into the future. Projections enable you to measure
anticipated cash generation and financial strength. In preparing these projections, you will
work with other sections of the spreadsheet that have not yet been covered.
The projections will be based on past trends and proposed new strategies. In building them,
you will draw on key financial concepts learned in Unit Two and on account relationships
encountered in the financial ratios of Units Four through Seven. By understanding these
relationships and the formulas for computing certain ratios, you
will be able to project numbers based on key assumptions.
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In preparing these projections, you must first analyze the customer's basis for his/her
projected figures to determine the feasibility of proposed financial strategies. In reaching
this determination, you, the analyst, will prepare your own projections based on your own
more pessimistic assumptions in an attempt to measure the sensitivity of the figures. This,
then, will depict an alternate, more conservative picture of what might happen if the
customer's financial strategies cannot be achieved and what this might mean in terms of
cash flow and potential additional cash needs. With this information, you will be better
prepared to reach conclusions and frame recommendations.
NOTE:
Comparison of the customer's projected numbers with the bank's more

conservative projected numbers is an important step in the credit process.
Mechanics of the Bank Spreadsheet Model
Before beginning the Tower case, let's review the format of the spreadsheet model. You
will find it on the four pages following this section.
The form begins with the balance sheet on the first page, then an income statement and
certain reconciliations on the second page, the cash generation statement, and finally, a
page with ratios. We have already worked with some of these parts, so let's discuss the
other parts.
Reconciliations
There are two reconciliations: fixed assets and net worth. We will focus on these key
accounts and "squeeze out" any items that should be considered later for calculating cash
flows. Also, by focusing on these reconciliations, you will understand what is happening on
the balance sheet with these important accounts.
1)
Fixed Asset Reconciliation
The fixed asset reconciliation begins with the opening net fixed assets for the period
which are the net fixed assets from the prior balance sheet. If the prior balance sheet is
not available, this computation cannot be made.
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After noting the opening net fixed assets, we subtract depreciation for the period.
Depreciation is the same figure that appears on the income statement. The subtotal is
then compared to the balance sheet net fixed assets. If the balance sheet number is
greater (as it usually is), it means that some fixed assets were acquired (or revalued)
during the period. The difference between the subtotal and the balance sheet net fixed
asset figure constitutes the capital expenditures for property, plant, and equipment
made during the period. Let's look at an example.
Opening Fixed Assets
Less: Period Depreciation
3,000
500
Subtotal
Ending Fixed Assets
2,500
2,800
Capital Expenditures
300
In this example, the ending fixed assets are less than opening fixed assets, even though
there was an increase in these assets during the period. If no other fixed assets had been
bought or sold during the year, the ending fixed assets would be 2,500, which is less
than the opening fixed assets by the factor of depreciation (500).
If the subtotal was greater than ending fixed assets, it would mean that some fixed
assets had been sold, or otherwise disposed of, during the period and had not been
replaced. The net effect would be a reduction of the balance sheet net fixed asset
account by an amount that is greater than depreciation.
The above example is a simplification of the concepts involved. The new Citibank
spreadsheet section for fixed asset reconciliation (below) covers the additional
concepts of inflation adjustments, revaluation, and type of capital expenditure.
It is important to consider these concepts.
73
74
75
76
77
78
79
80
81
82
83

Depreciation
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The inflation adjustment is for monetary correction of fixed assets. This is one of many
such adjustments within a monetary correction scheme.
As for revaluation, note that the previous simple calculation finds amounts of capital
expenditures by difference. In reality the amount of capital expenditures often
includes increases due to revaluation of fixed assets. These should be netted out, as in
the new spreadsheet, because these are accounting entries and do not reflect actual
acquisitions or cash movements.
The type of capital expenditure is also relevant. Maintenance capital expenditures
are for the purpose of replacing some fixed assets to enable continuing business at
essentially the same level. Expansionary capital expenditures enable a significant
increase in operational levels, such as installing new machinery to increase production
levels, or opening an additional retail outlet.
2)
Net Worth Reconciliation
The concept here is similar to that of the fixed asset reconciliation. The analysis begins
with the opening net worth figure, which is the same as the ending net worth of the
prior period. Again, this does not appear on the balance sheet, but must be sourced
from the prior periods balance sheet. If the prior figure is not available, the
computation cannot be made.
The net income (or loss, expressed as negative income) for the period is added to the
opening figure. The subtotal indicates what the ending net worth figure would be if no
other adjustments were made. If the ending figure is greater than the opening figure
plus net income, it means that capital was injected into the company during
the period, or that net worth was increased in some other way, in the amount of the
difference. If the ending figure is less than the opening figure plus net income, it means
that capital was taken out or reduced. A reduction usually indicates payment of
dividends, but there may be other reasons such as a write off of certain assets.
Opening net worth
Plus: net income
Subtotal
Difference
Ending net worth
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4,000
800
4,800
300
4,500
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In this example, ending net worth is less than opening net worth plus net income, which
means that there was a reduction of capital. We can assume that this was due to
dividends, but the reason for the difference should be confirmed with the customer.
It should be noted that these reconciliations are accounting exercises we are dealing
with arithmetical differences and not with theoretical possibilities. If the numbers
signal a difference, these amounts must be considered for cash flow purposes
regardless of the reason for the difference.
The new Citibank spreadsheet is now more sophisticated in this area, including lines for
inflation adjustments from monetary correction and balance sheet adjustments in the
case of foreign currency long-term debt devaluations.
The new net worth reconciliation looks as follows:
65
66
67
68
69
70
71
72

Opening Net Worth
Net Income
Dividends
Ending Net Worth
The Funds Generation Statement

This page of the Citibank spreadsheet directly focuses on the sources and uses of funds
concepts presented in Unit Two. The cash flow breaks down both sources into operational
and non-operational funds flows. By separating the flows into these distinct categories,
conclusions may be drawn about where funds have been used and about the sources for
these resource allocations.
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The groupings on the new spreadsheet are as follows:

+ Operating profit (sales - cgs - sga - deprec)
+ Depreciation
= Gross operating cash flow (GOCF or FFO)
- Operating uses (increase in receivables, inventory, other current assets)
+ Operating sources (accounts & taxes payable, other current liabilities)
= Net operating cash flow (NOCF)
- Maintenance capital expenditures
= Free operating cash flow (FOCF)
+ Non-operating sources (non-op income, fresh capital, new debt)
- Non-operating needs (dividends, expans. cap. expend., debt reduc.)
= Net increase / decrease in cash and equivalent
You will see an example of this in the case which follows. Notice that the customers
financial statements have already been spread using this format.
Background Tower Stores, Inc.

Tower Stores, Inc., is a family-owned commercial enterprise founded in 1952 in the
country of Casablanca. This third-world country has enjoyed relative economic and political
stability for over 20 years. The currency unit of Casablanca is the Peso, and the exchange
rate versus the US Dollar is Ps. 8.00 / US$1. The inflation level in Casablanca
is about 15%.
Tower Stores owns and manages several small department stores that sell clothing, shoes,
cosmetics, toys, televisions, other consumer electronics goods, and small kitchen and
household appliances. There are six stores, all well located throughout the country in
prestigious shopping centers or districts. The firm has earned an established and respected
market image by selling high quality products and by maintaining a reputation for
administrative integrity.
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The firm has been conservatively managed with a deliberate, but steady growth in operations
over the years. Several months ago, Teddy Tower, grandson of the founder, became general
manager of the company. He has worked in the family enterprise for four years since
graduating from a reputable business school in the USA where he specialized in marketing.
During his time in the company, he has gained experience in most of the major departments
of the firm, including the purchases, sales, finance, and administrative departments.
New Directions
Teddy believes the firm has been managed too conservatively over the years, resulting in
slim profitability. He thinks that the firm can achieve faster growth and greater
profitability with more aggressive sales policies involving increased credit terms from
present levels of about 25% (present maximum: 60 days) for the firm's select clientele.
Teddy also feels that trendier products could increase margins on the income statement
and accelerate inventory turnover. Teddy's idea is to cash in on the increasing purchasing
power of the growing middle class of Casablanca.
On the balance sheet, these changes would mean increased funding needs since
considerable increases in accounts receivable could be anticipated as a result of these
policies. This growth in receivables would result from the dual effect of the more
accelerated sales growth and the greater proportion of credit sales.
Teddy proposes to cover the anticipated increased funding needs from three sources:
n
Higher net income levels (plus depreciation)
More favorable average credit terms on purchases
Increased short-term bank financing
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Specific Short-Term Objectives

The financial statements for Towers Stores, Inc., have been spread and are attached.
Based on his own analysis of the company's situation and his assessment of the market,
Teddy Tower has just set goals for the year 19X4, which has just begun. Specifically, his
19X4 financial objectives for Tower Stores are to:
n
Increase sales by 30% (about 15% above inflation levels)
Credit sales to be 50% of total sales
Sales terms to average 60 days
Reduce cost of goods sold / sales to 62%
Maintain SGA expenses at 27% of sales
Increase inventory turnover to 3.5 times (103 days)
Increase purchase terms to an average of 45 days
Situation with Commerce Bank

Commerce Bank is the principal bank for Tower Stores and currently offers them a credit
facility for short-term borrowings of Ps. 5,000,000 ( US$ 625,000), with an average usage
factor of about 80%. Teddy Tower has requested that the bank increase this line of credit to
Ps. 8,000,000 to support the company's anticipated increase in working capital needs. The
existing facility is offered without tangible collateral, but with personal guarantees
of key shareholders.
Tower Stores is a prime customer of Commerce Bank. The company provides strong
account earnings through intensive use of the short-term facility and the significant
volumes of trade and current account operations that are channeled through the bank.
Although he did not anticipate consistent use of more than Ps. 5,000,000 of this line (the
rest of the short-term needs would be supplied by other banks), Teddy requested the full
amount to cover seasonal needs and to act as insurance in case the working capital needs
turned out to be heavier than expected.
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Company Name:
Country:
Amounts in 1= mill, 2 = thous, 3 = actuals:
Currency:
Local Curr enter 0, US$ enter 1:
Financials: Audited / Direct:
Qualified / Unqualified:
TOWER STORES, INC.

Casablanca
2
Pesos
0
Audited
Audited
Unqualified
Unqualified
Annual Data
Statements Purchasing Power Date:
12/31/X1
12/31/X2
Statement Date:
12/31/X1
12/31/X2
0
0
Audited
Unqualified
12/31/X3
12/31/X3
12
BALANCE SHEET
Line #
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
ASSETS
Cash
Marketable Secs
Acct Receivables
Inventory
15,907
19,228
21,363
5,157
5,028
226
360
-
21,531
24,482
27,160
2,151
880
2,827
3,957
880
3,696
5,240
880
3,909
320
612
9,430
11,318
12,122
-
9,000
621
2,551
880
-
9,000
550
11,242
1,760
-
446
767
-
9,558
2,640
-
9,000
705
-
3,543
5,333
15,038
37
Total Net Worth
12,101
13,164
38
21,531
24,482
27,160
39
40
41
Pledged Assets
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337
688
6,790
Preferred Stock
Common Stock
Capital Surplus
Reserves
Retained Earnings
Capital Revaluation
5,437
-

Total Liabilities
2,255
17,241
347
362
467
Minority Interest
262
327
2,627
14,958
505
301
LIABILITIES
Short-Term Debt
1,158
-
Total Assets
28
837
-
1,512
12,984
Net Fixed Assets

Other LT assets
Deferred Assets
29
30
31
32
33
34
35
36
822
-
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INCOME STATEMENT
Pesos Thousands
Annual Data
Statement Date:
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
Pesos Thousands
Net Sales
12/31/X1
12/31/X2
12
12
12
56,420
36,678
15,634
68,432
45,218
19,650
78,690
51,439
21,919
4,108
3,564
5,332

Operating Profit
Interest Income
FX income / (loss)
844
912
982
3,264
2,652
4,350
460
3,204
-
1,808
-
2,804
1,146
-
1,808
2,804

Minority interest
844
2,804

12/31/X3
3,204
-
1,808
3,204
61
Income Tax
1,262
745
1,330
62
63
Net Income (Loss)

1,542
0
1,063
0
1,872
0
1,542
1,063
1,874
12,101
1,063
0
0
0
0
0
13,164
1,874
0
0
0
0
0
13,164
15,038
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83

Opening Net Worth
Net Income
Dividends
Ending Net Worth

Depreciation
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5,157
912
0
0
0
783
783
0
783
0
5,028
982
0
0
0
1,391
1,391
0
1,391
0
5,028
5,939
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CASH FLOW
Pesos Thousands
Statement Date:
84
85
86
87
88
89
90
Pesos Thousands
Operating Profit
Other non-cash charges (Enter in section below)
Gross Operating Cash Flow (GOCF or FFO)
Changes in receivables
Change in inventories
Change in other current op.assets
90
91
92
93
94
12
4,350
982
0
5,332
(372)
2,283
(158)
Change in acc. & taxes payables

Change in other current op. liabilities
886
76
322
79
Net Operating Cash Flow (NOCF)
1,194
3,980
Maintenance Capital Expenditures

Free Operating Cash Flow (FOCF)
Net non-operating net income (net of non-cash)
Increase (Decrease) in Capital
Dividends from Subsidiaries & Affiliates
Sale of investments in Subs. & Affil.
Sale of fixed assets
Increase in S.T. Bk. & Financ. Debt
Increase in LT Bk. & Financ. Debt
Change in non-oper-non-fin curr Liabs.
Change in other LT liabilities
Change in Minority Interest
105
106
107
108
109
110
111
112
Growth of inv. in Subs., Aff. & Intangibles

Dividends Paid
Expansionary Capital Expenditures
Change in non-oper-non-fin curr assets
Change in other LT assets
Reduction in S.T. Bk. & Financ. Debt
Reduction in LT Bk. & Financ. Debt
Total Non-Operating Needs
Total Non-Operating Sources
783
1,391
411
2,589
(1,589)
0
0
0
0
1,806
0
0
0
0
217
0
0
0
(26)
(241)
0
880
Net Increase (Decrease) in Cash and Equivalents
(2,476)
0
0
0
0
1,283
0
0
0
0
(1,193)
0
0
0
61
134
0
880
613
1,075
15
321
112
CASH & EQUIV AT BEGINNING OF PERIOD
113
CASH & EQUIV END OF PERIOD
822
837
837
1,158
114
CASH & EQUIV AT END B/S
837
1,158
115
116
117
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12
2,652
912
0
3,564
1,115
1,974
243
95
96
97
98
99
100
101
102
103
104
105
112
12/31/X2
Unexplained Difference (CHECK)

Non-Cash Charges Breakdown
Total Other non-cash charges & B/S
118
119
120
Operational
121
122
123
124
125
126
127
Non Operational
FX loss / (gain)
Plus: Inf. Adjust. LT liabs. & N. worth
Less: Accrued profit related companies
Less: Other non-cash non-op income
Plus: Net change def. reserves
Less: Inf. Adjust. LT assets
Allowance for Bad Debts

Inventory Write-off
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0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
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RATIO ANALYSIS
Annual Data
Statement Date:
12/31/X1
12/31/X2
12
12
12
21,531
12,101
12,101
9,117
24,482
13,164
13,164
9,670
27,160
15,038
15,038
10,121
56,420
3,264
1,542
4,108
68,432
2,652
1,063
3,564
1,194
411
78,690
4,350
1,874
5,332
3,980
2,589
191
192
193
194

Total Assets
Net Worth
Tangible Net Worth
Working Capital
195
196
197
198
199
200
Net Sales
Operating Profit
Net Income
GOCF
NOCF
FOCF
201
202
203
204
OPERATING
205
206
207
208
209
210
211
212

Dividend payout ratio
65.0
27.7
5.8
2.7
7.3
2.62
0
-
12/31/X3
21.3
6.3
66.1
28.7
15.0
0
65.4
27.9
3.9
1.6
5.2
8.8
5.1
2.80
0
5.5
2.4
6.8
14.2
7.7
2.90
0
LIQUIDITY
213
214
215
216
217
218
219
Current ratio
Days receivables
Days inventory
Days payables
2.34
0.34
39
127
28
3.8
5
2.01
0.36
55
119
29
3.4
4
1.90
0.30
41
121
27
4.3
5
0.78
0.53
8.9
1.6
3.1
5,671
3,031
2,640
12,101
12,101
9,000
0.63
0.86
0.73
4.2
2.0
2.1
6,597
4,837
1,760
13,164
13,164
9,000
0.73
0.31
0.87
4.7
6.1
2.6
7,000
6,120
880
15,038
15,038
9,000
0.78
LEVERAGE
220
221
222
223
224
225
226
227
228
229
230
231

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EXERCISE 8.2
Directions: You are the new financial analyst for Commerce Bank. Your boss has asked
you to analyze Tower's financial statements and give an opinion about the
company's historical financial soundness. You are also to determine the
company's anticipated funds needs with their assumptions and with your own
adjusted numbers to test the sensitivity of the projections. Then, your boss
would like you to make conclusions about the overall financial analysis and
anticipated financial directions.
There are three parts to this exercise. Upon completion of each part, check
your answers with the Answer Key which follows the exercise.
PART I
Based on your knowledge of the Tower Stores financial statements, answer these questions
about the historical financial numbers included in the spreadsheet format.
Question 1: What does the vertical analysis indicate on the income statement?
a) Does it indicate major changes or stability?
b) Are operations getting better or worse?
c) Can definitive conclusions be reached?
What does the vertical analysis indicate on the balance sheet?
d) Does it indicate major changes or stability?
e) What is the relative composition of assets?
f) What is the relative composition of liabilities versus capital?
g) What are the significant swings in composition from year to year?
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EXERCISE 8.2
(Continued)
Question 2: What does the ratio analysis indicate?

a) What do liquidity ratios indicate about realizability of receivables and
liquidity of inventory?
b) Considering the type of enterprise, what do leverage ratios indicate about the
relative amount of capitalization?
Question 3: What does the cash generation analysis indicate?

a) What have been the principal operating cash needs?
b) What have been the non-operating cash needs, and how have these been
financed?
Question 4: Has financial performance been adequate?

a) Have liquidity, solvency, and profitability been sufficient?
b) Has return on sales been adequate?
c) Has return on equity been sufficient? To what should ROE be compared?
Question 5: How can financial performance be improved? What should Tower focus on
for improvement?
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ANSWER KEY
PART I
Suggestions for Analysis

Based on your knowledge of the Tower Stores financial statements, answer these questions
about the historical financial numbers included in the spreadsheet format.
Question 1: What does the vertical analysis indicate on the income statement?
a) On the income statement, the vertical (or margin) analysis indicates
stability from period to period since there are no major changes.
b) The numbers demonstrate some recuperation in 19X3, relative to 19X2,
as greater profits were achieved.
c) It is difficult to achieve more meaningful analysis without industry or
competitor figures.
What does the vertical analysis indicate on the balance sheet?

d) On the balance sheet, the vertical analysis indicates stability with no major
swings in account composition.
e) Typically, for a commercial firm, current assets predominate over fixed and other
non-current assets. This situation has been accelerated in the past two years.
f) The composition of fewer liabilities than capital indicates a strong solvency, with
a leverage figure of less than 1.00. We will discuss this further in the next answer
about ratios.
g) On the asset side, there has been a great deal of stability with a slight build
up in inventory and a relative reduction in net fixed assets in 19X3. On the liability
side, the most notable swing has been a relative build up in short-term bank debt
as long-term debt has been paid down.
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PART I: Answer Key (Continued)

In summary, other than reflecting a great deal of stability within the company,
the vertical analysis tells us relatively little without a further basis for
comparison. However, the demonstrated stability is a useful observation when
considered within the rest of the analysis. We can anticipate that, with the
proposed changes, there is risk that this stability could be compromised in
the future.
Question 2: What does the ratio analysis indicate?

a) The ratios seem to indicate a historically strong liquidity and solvency position for the
company, although liquidity has been decreasing. The decreased liquidity apparently
is due to improved inventory turnover and to increased levels of short-term bank
debt. The receivables turnover figures appear to be well within established credit
terms and receivables are placed with an established clientele. The principal current
assets of receivables and inventory, therefore, appear to support the liquidity
situation with realizable assets.
b) Leverage is quite strong at less than 1.00. This ratio indicates that Tower is not a
great credit risk since the creditors are amply covered by the firm's assets. This is
especially true when you consider that Tower Stores is a commercial enterprise. Due
to the liquidity of its assets, this type of firm normally reflects a higher range
of debt to equity than industrial enterprises.
Question 3: What does the cash generation analysis indicate?

a) The major funds needs in 19X2 were accounts receivable (34% of total operating
needs) and inventory (59%), together totaling over three million pesos in funds needs
for the year. In 19X3, the inventory increase was virtually all of the operating needs
for the year.
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b) Non-operating needs almost exclusively were for capital expenditures and reduction
of long-term bank debt. These were funded by short-term bank debt in 19X2, and by
net operating generation plus short-term bank debt in 19X3. While funding capital
expenditures with short-term debt is not advisable, the amounts are small (3% of total
assets in 19X2 and 5% in 19X3) and in the last year leverage was reduced.
Question 4: Has financial performance been adequate?

a) Given that both liquidity and solvency of the firm appear to be strong, this question
now revolves around the question of profitability.
b) On a comparative basis from year to year, the return on sales (ROS) percentage
improved in year 19X3 (2.4%) after a decrease in 19X2 (1.6%). However, an outside
reference is needed in order to gauge the validity of the present figure. To determine
the adequacy of financial performance, you must focus on return on equity instead of
return on sales.
c) The return on equity (ROE) figure should be compared to outside references, such
as alternative investments in the marketplace and the inflation figure. It appears
that Tower's ROE figure of 13.3% for 19X3 is about even with inflation, so from an
investment point of view, the figure is approaching an adequate range, but cannot
be considered strong.
Because the ROE figure is at the lower range of acceptability, we may conclude
that profitability performance has been acceptable, but could be better. At least
profits have been highly stable. Teddy Tower may be correct in believing that the
firm has been managed too conservatively, especially when considering that the
12/31/X3 leverage (debt / equity) figure of 0.81 is low for a commercial enterprise.
If the ROS figure could be improved, and the firm leveraged up somewhat, the
ROE could be boosted significantly.
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Question 5: How can financial performance be improved? What should Tower focus on
for improvement?
To improve this ROE figure, management could focus on some key variables to
improve overall ROE through greater operational and financial efficiency. This
analysis is based on the relationships that exist between the profitability
indicators and other key ratios, as follows:
Asset
Turnover
ROS
ROE
Net Income
Net Sales
Asset
Leverage
ROA
Net Sales = Net Income

Total Assets
Total Assets
Total Assets = Net Income

Net Worth
Net Worth
Notice that both asset turnover and asset leverage are multipliers. If these ratios
can be increased without negatively impacting the ROS, then overall ROE will be
increased. This is why it is important for all assets to contribute to sales, and why,
therefore, it is important to avoid allocating resources to unproductive assets.
Obviously, increasing ROS also will ultimately boost ROE if these multipliers do
not decrease.
The asset leverage figure is similar to the traditional debt / equity concept.
Remember, the asset leverage will always be 1.00 greater than the debt leverage
figure. For example, if debt / equity is 1.28, then the asset / equity figure will be
2.28, etc.
From the investor's viewpoint, it is, therefore, more desirable to leverage up to
produce a greater ROE figure. However, this must be done within an acceptably
narrow range to avoid sacrificing profitability (because of higher interest
expenses) and creditworthiness, thereby nullifying the intended effect.
If we analyze the Tower numbers in this way, we get the following:
Asset
Turnover
ROS
2.4%
3.05
Asset
Leverage
ROA
=
7.3%
1.81
ROE
=
13.3%
To improve the company performance, Teddy Tower could focus first on

improving operational efficiency by lowering costs in relation to sales. Then,
he could attempt to utilize total assets more efficiently (to improve the asset
turnover) and fund asset growth with debt, thereby leveraging up somewhat.
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EXERCISE 8.2
PART II
Complete the following projection exercises for both the customer's assumptions and your
own sensitivity analysis assumptions. Enter your figures on the abbreviated spreadsheets
provided for each part of the exercise.
Projection 1: Project the income statement accounts requested. Use the following
customer assumptions for the first projection:
n
Sales growth
30%
Cost of goods sold / sales
62%
Selling, general, and

administrative expenses / sales
27%
Depreciation
Ps. 1,200,000
Interest expense
Ps. 2,000,000
Income tax rate
45%
For your own sensitivity analysis, assume instead:
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Sales growth
20%
Cost of goods sold / sales
65%
Selling, general, and

administrative expenses / sales
28%
Depreciation
Ps. 1,200,000
Interest expense
Ps. 3,500,000
Income tax rate
45%
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EXERCISE 8.2 (Continued)

Calculation
For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20%
respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62%
CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA
expenses. Then insert the figures assumed for depreciation and interest and calculate the
percentages.
12 Month
Actual
12/31/X3
INCOME STATEMENT
12 Month
Customer
Projection
12 Month
Sensitivity
Projection
15
30
20
78,690
51,439
21,919
5,332
100
65
28
7
100
100
Depreciation
Interest Expense
982
1,146
1
1
Earning Before Taxes

Income Taxes
Extraordinary Items
3,204
1,330
0
4
2
0
Net Income
1,874
Sales Growth Rate

Net Sales
Cost of Goods Sold
Selling, General Admin. Expense
Operating Margin
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ANSWER KEY
PART II
Calculation
For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20%,
respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62%
CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA
expenses. Then, insert the figures assumed for depreciation and interest and calculate the
percentages.
PART II: Answer Key (Continued)
12 Month
Actual
12/31/X3
INCOME STATEMENT
Sales Growth Rate
Net Sales
Cost of Goods Sold
Selling, General Admin. Expense
Operating Margin
12 Month
Customer
Projection
12 Month
Sensitivity
Projection
15
30
20
78,690
51,439
21,919
5,332
100
65
28
7
102,297
63,424
27,620
11,253
100
62
27
11
94,428
61,378
26,440
6,610
100
65
28
7
Depreciation
Interest Expense
982
1,146
1
1
1,200
2,000
1
2
1,200
3,500
1
4
Earning Before Taxes

Income Taxes
Extraordinary Items
3,204
1,330
0
4
2
0
8,053
3,624
0
8
4
0
1,910
860
0
2
1
0
Net Income
1,874
4,429
1,050
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EXERCISE 8.2
(Continued)
Projection 2: Project the accounts receivable, inventory, and payables accounts under the
customer's assumptions and under your own sensitivity assumptions. Then,
calculate the amount of increase over the 12/31/X3 numbers. Use the
abbreviated format below.
The methodology for this is based on the relationships in the formulas for
days receivable, days inventory, and days payable.
For example, once we have a figure for sales and the number of days
receivable, we can project the accounts receivable as follows:
Credit Sales
360
X Number of Days (Sales Terms)
We can also project the days inventory figure, now that we have determined
the cost of goods sold and the number of days inventory. The calculation
would be:
Cost of Goods Sold
360
X Number of Days (Inventory)
The accounts payable calculation would be:

Cost of Goods Sold
360
X Number of Days (Payable)
For these projections, the customer's assumptions are:
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Credit sale / sales
50%
Sales terms average
60 days
Average days inventory
103
Average days payable
45 days
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EXERCISE 8.2 (Continued)

Your sensitivity figures should be based on:
n
Credit sale / sales
50%
Sales terms average
75 days
Average days inventory
120
Average days payable
30 days
12 Month
Actual
12/31/X3
BALANCE SHEET
Accounts Receivable
12 Month
Customer
Projection
12 Month
Sensitivity
Projection
%*
%*
2,255
xx
xx
17,241
63
xx
xx
3,909
14
xx
xx
Increase from 12/31/X3

Inventory
Accounts Payable
* These vertical analysis percentages cannot be computed until a figure for total assets is projected.
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ANSWER KEY
PART II
Projection 2: Project the accounts receivable, inventory, and payables accounts under the
customer's assumptions and under your own sensitivity assumptions. Then,
calculate the amount of increase over the 12/31/X3 numbers. Use the
abbreviated format below.
12 Month
Actual
12/31/X3
BALANCE SHEET
Accounts Receivable
%
2,255

Inventory
12 Month
Customer
Projection
%
8,525
xx
9,836
6,270
17,241
63
18,146

Accounts Payable
12 Month
Sensitivity
Projection
7,581
xx
20,459
905
3,909
14
7,928
xx
xx
3,218
xx
4,019
5,115
xx
1,206
Calculations
Accounts
Receivable
(102,297 x .50) x 60
360
(94,428 x .50) x 75
360
Inventory
63,424 x 103
360
61,378 x 120
360
Accounts
Payable
63,424 x 45
360
61,378 x 30
360
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EXERCISE 8.2
(Continued)
Projection 3: Based on the projections you have calculated, and the following additional
assumptions about the customer's and your own figures, calculate the
projected net funds needs under both the customer's and your own sensitivity
scenarios. The calculation should be Additional Funds Needs less Additional
Funds Sources. Please note:
Customer
500
Ps. 500,000 for "increase in other current assets"
Ps. 200,000 for "increase in other current liabilities"
Ps. 2,000,000 in net "capital expenditures"
Ps. 880,000 in "long-term debt" payments
There is no new "long-term debt"
Sensitivity
500
+ Additional Funds Needs

Operating:
Increase in Receivables
Increase in Inventory
Increase in Other Current Assets
Non-Operating:
Reduction of Long-Term Debt
Additional Funds Needs
Additional Funds Sources
Net Income
Depreciation
Increase in Accounts Payable
Increase in Other Current Liabilities
= Net Needs to Be Covered
Net Additional Funds Needs
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ANSWER KEY
PART II
Projection 3: Based on the projections you have calculated, and the following additional
assumptions about the customer's and your own figures, calculate the
projected net funds needs under both the customer's and your own sensitivity
scenarios. The calculation should be Additional Funds Needs less Additional
Funds Sources. Please note:
Customer
Ps. 500,000 for "increase in other current assets"
Ps. 200,000 for "increase in other current liabilities"
Ps. 2,000,000 in net "capital expenditures"
Ps. 880,000 in "long-term debt" payments
There is no new "long-term debt"
Sensitivity
6,270
905
500
7,581
3,218
500
+ Additional Funds Needs

Operating:
Increase in Receivables
Increase in Inventory
Increase in Other Current Assets
2,000
880
2,000
880
Non-Operating:
Reduction of Long-Term Debt
10,555
14,179
4,429
1,200
4,019
200
1,050
1,200
1,206
200
9,848
3,656
707
10,523
Additional Funds Needs

Net Income
Depreciation
Increase in Accounts Payable
Increase in Other Current Liabilities
= Net Needs to Be Covered
Net Additional Funds Needs
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EXERCISE 8.2
(Continued)
Projection 4: Project the entire balance sheet using the numbers you developed earlier in
this exercise. Enter the numbers in the appropriate boxes below. Note the
following:
n
The amount determined earlier for net additional funds needs

should be added to the short-term bank debt account.
Net income should be added to retained earnings.
Fixed assets should be adjusted for depreciation.
Some balance sheet items must be bundled together for this

format.
BALANCE SHEET
Accounts Receivable
Inventory
Cash & Other Current Assets
2,255
17,241
1,867
8
63
7
Current Assets
21,363
79
Net Fixed Assets

Other Non-current Assets
5,437
360
20
1
Non-current Assets
5,797
21
TOTAL ASSETS
Accounts Payable
Current Portion LTD
27,160
100
5,240
3,909
1,213
880
19
14
4
3
11,242
41
880
12,122
45
9,000
705
5,333
33
3
20
TOTAL NET WORTH
15,038
55
27,160
100
Current Liabilities
Long-term Debt
TOTAL LIABILITIES
Common Stock
Surplus and Reserves
Retained Earnings
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ANSWER KEY
PART II
Projection 4: Project the entire balance sheet using the numbers you developed earlier in
this exercise. Enter the numbers in the appropriate boxes below. Note the
following:
n
The amount determined earlier for net additional funds needs

should be added to the short-term bank debt account.
Net income should be added to retained earnings.
Fixed assets should be adjusted for depreciation.
Some balance sheet items must be bundled together for this

format.
12 Month
Actual
12/31/X3
BALANCE SHEET
12 Month
Customer
Projection
12 Month
Sensitivity
Projection
Accounts Receivable
Inventory
Cash & Other Current Assets
2,255
17,241
1,867
8
63
7
8,525
18,146
2,367
24
51
7
9,836
20,459
2,367
25
52
6
Current Assets
21,363
79
29,038
81
32,662
83
Net Fixed Assets

5,437
360
20
1
6,237
360
18
1
6,237
360
16
1
Non-current Assets
5,797
21
6,597
19
6,597
17
27,160
100
35,635
100
39,259
100
5,240
3,909
1,213
880
19
14
4
3
5,947
7,928
1,413
880
17
22
4
2
15,763
5,115
1,413
880
40
13
4
2
11,242
41
16,168
45
23,171
59
880
12,122
45
16,168
45
23,171
59
9,000
705
5,333
33
3
20
9,000
705
9,762
25
2
27
9,000
705
6,383
37
2
16
TOTAL NET WORTH
15,038
55
19,467
55
16,088
41
27,160
100
35,635
100
39,259
100
TOTAL ASSETS
Accounts Payable
Current Portion LTD
Current Liabilities
Long-term Debt
TOTAL LIABILITIES
Common Stock
Surplus and Reserves
Retained Earnings
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EXERCISE 8.2
(Continued)
Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio,
and return on average equity figures for both the customer projection and the
sensitivity projection.
12 Month
Actual
12/31/X3
RATIO CALCULATIONS
Leverage
12,122 / 15,038
0.81
Current Ratio
21,363 / 11,242
1.90
Return on Average Equity
1,874 / 14,101
13.3%
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Customer
Projection
12 Month
Sensitivity
Projection
8-72
ANSWER KEY
PART II
Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio,
and return on average equity figures for both the customer projection and the
sensitivity projection.
12 Month
Actual
12/31/X3
12 Month
Customer
Projection
12 Month
Sensitivity
Projection
Leverage
12,122 / 15,038
0.81
16,168 / 19,467
0.83
23,171 / 16,088
1.44
Current Ratio
21,363 / 11,242
1.90
29,038 / 16,168
1.80
32,662 / 23,171
1.41
Return on Average Equity
1,874 / 14,101
13.3%
4,429 / 17,253
25.7%
1,050 / 15,563
6.7%
RATIO CALCULATIONS
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EXERCISE 8.2
(Continued)
PART III
Directions: Check your understanding of the Tower Stores, Inc., case by answering the
following questions. Check your answers with the Answer Key that follows.
Question 1: Select the best description of Tower's historical financial situation.

____ a) Adequate liquidity, but a weak capital position
____ b) Strong capitalization and considerable stability
____ c) Poor loan prospective due to relative instability
____ d) Strong according to customer projection, but weak according to the
sensitivity projection
Question 2: Which account will incur the most significant changes in the company's
future cash generation needs if Teddy Tower proceeds with his more
aggressive marketing ideas?
____ a) Increased funding for accounts receivable
____ b) Decreased funding for capital expenditures
____ c) Increased funding for reduction of bank debt
____ d) Increased inventory funding needs
Question 3: Select the two principal funds sources that Teddy Tower is counting on, in
accordance with his own projections.
____ a) Bank loans
____ b) Strong earnings
____ c) Significant increases in credit terms from suppliers
____ d) Capital investment
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EXERCISE 8.2
(Continued)
Question 4: What is the advisability of approving the customer's request for the increase
in credit facilities?
____ a) Approvable without reservation, due to the firm's strong capitalization
____ b) Not approvable because of the risk of future shortages of funding sources
____ c) Approvable with caution, due to the firm's ambitious marketing plans
____ d) Not approvable because Teddy Tower's reputation for sound business
decisions is questionable
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ANSWER KEY
PART III
Suggestions for Analysis
Question 1: Select the best description of Tower's historical financial situation.

b) Strong capitalization and considerable stability
Summarizing our comments for Question 1 of Part I, we can conclude that the
Tower firm has a strong balance sheet reflecting a healthy liquidity and a
robust capital position. Earnings may be lagging behind expectations from an
investor's point of view, perhaps due to overly conservative management.
Nevertheless, from a creditor's perspective, the numbers indicate a strong
potential for lending primarily because of the strong capitalization relative to
debt and the considerable stability reflected in the financial figures.
Question 2: Which account will incur the most significant changes in the company's
future cash generation needs if Teddy Tower proceeds with his more
aggressive marketing ideas?
a) Increased funding for accounts receivable
Without any changes in management focus or policies, the situation probably will
continue as in the past. Steady profits and depreciation will be the major elements
of coverage for the company's moderately increasing funds needs. The
remaining funds needs probably will be covered by modest increases in debt,
although leverage probably will remain at similar levels.
If Teddy Tower proceeds with his more aggressive marketing ideas, there may be
significant changes in the financial numbers. Major sales increases will have
parallel (due to growth) and accelerated (due to increased credit sales and terms)
effects on current assets, primarily receivables. These receivables increases will
create funds needs in the range of six to seven million pesos (as calculated in the
customers, and our own, sensitivity numbers).
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PART III: Answer Key (Continued)

Teddy proposes to improve the inventory turnover ratio, which will only slightly
increase inventory funds needs (Ps. 905,000 according to his figures).
However, if this improved turnover cannot be achieved and historical ratios are
maintained, the needs would be in the area of three million pesos.
Question 3: Select the two principal funds sources that Teddy Tower is counting on, in
accordance with his own projections.
b) Strong earnings
c) Significant increases in credit terms from suppliers
For sources of funds, Teddy counts on strong earnings increases and significant
increases in credit terms from suppliers, as depicted in our answer to Part II
Projection Three. If both of these are achieved, then Teddy's outside funds needs
will be minimal. If either of these sources fails by any significant amount, or if
funds needs turn out to be much greater than anticipated, the balance will have to
be covered with outside debt.
In terms of total funds needs, the customer analysis and our own sensitivity
analysis present a wide variance, from less than Ps. one million to ten million
plus. On the asset side, the most critical needs are receivables and inventory;
on the funding side, the most critical variables are earnings and supplier credit.
Earnings may be the most critical variable of all, since higher anticipated debt
levels will generate higher interest payment requirements that must be covered
by increased earnings. If net income cannot be increased in proportion to sales,
the new strategy will be a failure.
The financial feasibility of attaining the customer's figures will then rest on
management's and the firm's abilities to achieve the projected sales with
increased margins, and to control the current assets within the constraints the
customer has fixed for himself. To the extent that implementation of these
policies falls short, funding needs may rise in direct proportion.
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PART III: Answer Key (Continued)
Question 4: What is the advisability of approving the customer's request for the increase
in credit facilities?
c) Approvable with caution, due to the firm's ambitious marketing
plans
From the financial perspective, Teddy Tower's request is "approvable," given
the firm's strong capitalization that will permit absorption of greater debt levels
and risk without adversely affecting the company's solvency.
Ultimately, the advisability of approving the request depends on qualitative
credit factors such as the banker's assessment of Teddy Tower's (and his
firm's) capabilities to go forward with their ambitious plans. At this point, the
firm has a steady record, an existing relationship with the bank, and a lot of
credibility on its side positive points in the overall credit determination.
If there are doubts about the strategy, the banker should closely watch drawings
under the existing (or increased) credit facility and monitor the pulse of the
situation. This is especially true for the key variables of sales, the CGS / sales
margin, and receivables, inventory, and payables levels to judge conformity
with Tower plans.
Congratulations! You have completed the Financial Statement Analysis workbook. We

suggest that you continue to refer to it as a ready reference particularly the Summary of
Financial Ratios at the end of Unit Seven.
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Appendices
APPENDIX A: ACCOUNTING EXERCISE

ANSWER KEY
Exercise Page 1-6
Part 1:
Balance Sheet
Assets
Liabilities
Cash
Accounts receivable
Inventory
Prepaid expenses
Current Assets
50
150
500
600
100
100
1500

Accounts payable
Accruals
Taxes payable
Current portion LTD
Current liabilities
Net fixed assets

Investments
License rights
Non-current assets
1000
300
200
1500
Long term debt

Oblig employee pension
Non-current liabilities
Total assets
3000
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600
250
150
50
100
50
1200
200
100
300
Total liabilities
1500
Capital stock
Legal reserve
Retained earnings
Total net worth
800
100
600
1500
Liabilities + Net worth
3000
A-2
ACCOUNTING EXERCISE
Part 1:
Income Statement
Net sales
+ 3000
- 2000
= 1000
- 300
= 700
- 100
- 150
50
= 400
- 100
= 300
Cost of goods sold

Gross margin
Selling, general, administrative expense
Operating margin
Depreciation
Interest expense
Other expense
Profit before taxes
Income tax expense
Net Income
Part 2: Short term Bank Debt, Retained Earnings, Balance Sheet Totals, and Income
Statement Subtotals?

Ending retained earnings
Total current assets
Total non-current assets
Total assets
Total current liabilities
Total non-current liabilities
Total liabilities
Total net worth (stockholders equity)
Gross margin
Operating margin
Profit before taxes
Net income
600
600
1500
300
300
l
1500
3000
1200
l
1500
1500
1000
700
400
l
l
*
l
l
l
l
l
l
l
l
* NOTE: Ending retained earnings is calculated as:

Prior year ending retained earnings + Net Income x Dividends
350 + 300 x 50 = 600
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APPENDIX B:
FINANCIAL STATEMENT STRUCTURE
INTRODUCTION
A business is a collection of economic and human resources devoted to a particular purpose
or goal. This business may be in the commercial, industrial, agricultural, service, or other
sectors. Whatever its purpose, every organization must measure its efforts in monetary
terms, for both legal and business reasons.
Accounting is the recording, summarizing, and reporting of transactions following certain
generally accepted accounting principles. These principles are similar throughout the world,
but vary in detail from country to country.
OBJECTIVES
In this section we will examine the structure of the balance sheet and the income statement.
When you complete this section, you will be able to:
n
Define accounting and its importance in the financial world
Describe the purpose of the balance sheet and income statement and classify
their accounts
Recognize three accounting principles that have special relevance to the

income statement
Prepare a simple balance sheet and income statement
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FINANCIAL STATEMENTS
The information recorded during the accounting process is
summarized and reported in the financial statements. There are two
basic financial statements:
n
Balance Sheet
Income Statement, also known as profit and loss statement
The balance sheet shows the financial position of a company at a

given date; it is a "snapshot" of a company's financial situation. The
income statement summarizes what has happened to the company
during a specific period, usually one year or less, and, therefore, is
a historical summary.
Accrual basis
Today, financial statements are almost always prepared on an accrual

basis, which means that events are recognized in the period to which
they refer even if the related cash transaction takes place in another
period. For example, if March rent is payable April 5, it is recognized
as a March expense. If 1989 income tax is paid in 1990, it is still a
1989 expense.
Auditors
The financial statements of many companies are examined by outside
accountants, known as auditors. A company hires an outside auditing
firm either to comply with a legal or regulatory requirement or
because the company values their professional services. Because
audited financial statements are usually more reliable, many bankers
will not process a loan request unless it is accompanied by financial
statements that have been examined by an acceptable auditing firm.
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Auditors'
opinions
As a result of their work, auditors issue a report that presents their

opinion on the reliability of a company's financial statements. It is not
an opinion on the financial health of the company. The analyst
determines whether or not the company is financially healthy.
Unqualified
opinion
An auditor's opinion is called an "unqualified opinion" if it is similar to

the following:
"In our opinion, the financial statements present fairly,
in all material respects, the financial position of the
company at (date), the results of its operations, and the
changes in its financial position for the year in conformity
with generally accepted accounting principles."
An unqualified opinion means that the auditors believe the financial

statements are reliable.
Qualified
opinions
Auditors also may qualify their opinions, stating that they do not agree
with the manner in which the company accounted for certain
transactions. In this case, the banker should carefully consider the
qualification and adjust the financial statements for purposes of
financial analysis. For example, if the auditors claim that the company
failed to report certain losses, and the analyst agrees with them, the
analyst must adjust the financial statements for those losses before
performing an analysis.
In the worst cases, the auditors also may disclaim an opinion on
the financial statements or report that the statements do not fairly
present the financial position of the company and the results of
its operations. This means that the auditors consider the financial
statements unreliable. In those cases, it is probably unwise to make
any type of loan to the company.
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B-4
Impact of
inflation
The effect of inflation on financial statements can be significant.

The analyst must understand how the numbers are affected in
order to draw the appropriate conclusions. In a higher inflationary
environment, the numbers will grow much more rapidly, both on
the balance sheet and the income statement. The analyst must
thoroughly understand the interaction of the numbers to isolate the
inflationary effects from the business activities of the enterprise.
Issues pertaining to the effects of inflation on financial statements are
covered in Unit One.
In the remainder of this appendix, we will discuss the concepts and
accounts of the balance sheet and income statement. Our example
company is CPT, Inc., and we begin with the balance sheet for
December 31, 19X1 and 19X2, which is presented on the next page.
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B-5
BALANCE SHEET CPT, INC.

DECEMBER 31, 19X1 AND 19X2
ASSETS
19X1
19X2
CURRENT ASSETS
Cash
Marketables Securities
Trade Receivables, Net
Inventory
Prepaid Expenses
1,122
1,820
12,204
17,037
1,603
756
1,861
1,200
14,859
20,018
1,922
560
34,542
40,420
Property, Plant, & Equipment

Less: Accumulated Depreciation
22,533
5,821
23,305
7,915
PPE, Net
16,712
15,390

Inter-Company Receivables
Investments
Intangibles
Deferred Charges
Other Accounts Receivable
422
1,716
744
301
269
387
1,858
1,018
360
359
Total Other Non-current Assets
3,452
3,982
54,706
59,792
Due to Banks
Trade Payables
Customer Advances
Accruals
Taxes Payable
Current Portion of Long-term Debt
12,522
7,341
1,421
990
456
558
1,845
11,580
9,194
1,988
1,148
892
376
2,110
NON-CURRENT ASSETS
TOTAL ASSETS
CURRENT LIABILITIES
25,133
27,288
LONG-TERM LIABILITIES
Long-term Debt
Long-term Deferred Liabilities
8,845
1,863
7,355
2,289
Total Long-term Liabilities
10,708
9,644
TOTAL LIABILITIES
35,841
36,932
NET WORTH
Capital Stock
Capital Reserves
Retained Earnings
10,000
1,667
7,198
12,000
1,882
8,978
TOTAL NET WORTH
18,865
22,860
54,706
59,792
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B-6
BALANCE SHEET
The balance sheet shows a picture of the financial position of a
company at a given date. It is divided into:
Basic
accounting
equation
Assets
Liabilities & Net Worth (owners' or shareholders' equity)
The basic structure of the balance sheet is always the same and can be
translated into this equation:
Assets = Liabilities + Net Worth
Look at the sample balance sheet on page B-5. Notice that assets
and liabilities plus net worth reflect account balances at the end of
a specific period. These accounts indicate the financial position of
CPT, Inc. Let's take a closer look at these accounts.
ASSETS
Assets include the resources owned by a company, such as cash,
inventories, or buildings, plus the claims it has against the resources
of other individuals or companies, such as accounts receivable.
Asset valuation
One of the main accounting principles states that assets should

generally be valued at the lower of cost or market. The principle
works as follows:
A company buys an asset for $1,000. As long as the market price is
$1,000 or more, it must be shown in the balance sheet at cost. If the
market price falls to less than the original cost, the item must be
shown at the new market price.
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This is an additional protection for creditors who can be reasonably

sure that assets are worth at least what the balance sheet says, and
probably even more. However, when inflation rates become very high,
marking assets at the lower of cost or market may distort asset values
to the extent of causing the financial statements to be useless. This
problem is so important that it will be covered separately in the
section on inflation.
Assets are usually classified in the balance sheet in the order they are
realized.
Realizing assets
Realizing an asset means to convert it into cash. For example, if

you sell an item for cash, you are realizing it at the same time you
are selling it. However, if you sell it on credit, you only realize it
when the bill is collected. Asset realizations create an inflow of funds
into the company. The earlier an asset can be realized, the more liquid
it is.
Classifying
assets
Based on intended realization times, assets may be classified as:
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Current Assets assets that the company intends to realize

within one year
Non-current Assets assets the company intends to realize

after one year. These are generally divided into:
Long-term Receivables receivables the company

intends to realize after one year of balance sheet date.
Fixed Assets assets acquired with the intention of

keeping them on a permanent basis.
Investments stock in other enterprises which the

company intends to keep on a more or less permanent
basis.
Deferred Assets assets that will be amortized on

a long-term basis.
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B-8
Of course, not all assets of the same group will be realized on the
same date, which means that asset realizations may create an uneven
inflow of funds.
Current Assets
To be labeled as current, an asset must meet two conditions:
1. The company must intend to realize it within one year.
2. The company must be able to realize it within one year.
Example:
intend to realize
For example, a company may own shares in another company that can
be sold immediately in the stock exchange. However, if the company
intends to keep the shares for more than one year because the
investment is considered profitable, then the shares cannot be labeled
as current assets.
Example: be
able to realize
Conversely, a company may own non-transferable bonds that mature

after one year. The bonds can never be considered current because of
the inability to realize within one year.
Current assets include:
Accounts
Cash Cash on hand plus demand bank deposits and items which will
be converted into cash within approximately 48 hours (such
as undeposited checks). Amounts in foreign currencies must be
translated into local currency at the exchange rates prevailing at
balance sheet date.
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Marketable Securities (or Cash Investments) Liquid securities

in which the company invests excess cash to earn interest. Often
the securities are long-term government or private fixed-income
securities. They are classified as current assets because the company
does not intend to keep them until final maturity and they can be
disposed of without any financial penalty.
Receivables Amounts due from clients for goods or services
bought from the company (trade receivables). The total amount of
trade receivables must be adjusted by an allowance for doubtful
debtors to cover possible shortfalls on uncollectible accounts. In most
cases, this allowance is set at the maximum allowed by income tax
regulations. Companies expecting higher losses should increase the
allowance so that net accounts receivable actually reflects the amount
the company will collect.
Receivables includes any amounts owed by related parties (companies
in the same group, including shareholders, officers, or employees),
which must be listed separately. The analyst should reclassify as longterm those accounts which probably will not be repaid within one year.
Inventories Raw materials, work in progress, and finished goods.
This account is peculiar because market values of inventories may
actually be lower than historical costs, as in the case of commodities
whose prices may fluctuate widely.
Prepaid Expenses Amounts paid in advance for goods or services,
such as insurance premiums and rent. Once the goods or services are
used, the related amounts must be expensed (transferred from assets
to an expense account).
Other Current Assets Any other assets that will be consumed or
liquidated within one year. These usually include several rather
insignificant accounts.
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B-10
Non-Current Assets
Fixed Assets Formally known to accountants as Property, Plant,
and Equipment ( PPE), or Premises and Equipment, include all items
used by the company to produce goods or render services, such as
office and plant buildings, machinery, and furniture. Intended use
matters more than type of asset. For instance, a car rental company
owns cars as fixed assets, but a car dealer owns them as inventories.
Fixed assets must be shown net of accumulated depreciation.
Depreciation
Depreciation is an accounting procedure that allows the cost of a fixed

asset to be charged to income earned during all the years the asset is
expected to remain in use. For example, if an asset that has been
purchased for $10,000 is expected to remain in use for 10 years, its
book value is reduced by $1,000 a year. After that period, the asset
will be fully depreciated and assigned a nominal value, such as $1,
until it is sold or otherwise disposed of.
The useful life of an asset is determined based on rules laid down by
the accounting profession and/or income tax regulations. Usually,
depreciation is applied by the straight-line method, which means that
the asset is depreciated at the same rate during its entire life.
Depreciation applies to all fixed assets except land. It has nothing to
do with devaluation. Even a fully depreciated asset may be quite
valuable at going market prices. Old machines, for instance, may by
refurbished or sold as scrap for a lot more than their nominal book
values.
Accumulated Depreciation An account that reflects the total
depreciation deducted from the company's fixed assets since the
assets were put into operation. This usually involves several years
worth of annual depreciation.
You will learn more about depreciation when we discuss the income
statement.
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B-11
Other Non-current Assets include the following sub-accounts:

Sub-accounts
Long-term Receivables Generally result from special

operations, such as intercompany loans or loans to shareholders,
officers, and employees which will not be collected within twelve
months. The account seldom includes trade receivables and is
usually only important for financial institutions that make longterm loans.
This account may also include deposits at government banks in
connection with imports and/or foreign loan operations. Although
those deposits usually earn interest, they may tie up a large amount
of cash and be a considerable hindrance to business in certain
countries.
Investments Securities the company does not intend to
dispose of. They usually comprise shares in associated and
controlled companies. Investments may be valued in two
different ways:
n
At the lower of cost or market
At equity
The rule of lower of cost or market has already been explained

and generally applies to lesser investments. More important
investments are shown at equity, a method that better reflects their
value because it is based on the owners' share in the net worth of
the company in which the investment is maintained,
in accordance with the investee company's own financial
statements.
Intangibles Assets such as goodwill, patents, copyrights, and
special licensing agreements. Special rules must be followed for
valuation of these accounts.
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B-12
Deferred Charges Items, such as preoperating expenses

or research and development that will result in benefits to the
company over a number of years. They are similar in nature
to prepaid expenses, but are always non-current.
Amortization
Amortization, an accounting procedure similar to depreciation, allows

the cost of a fixed deferred charge to be allocated to income earned
during all the years the asset is expected to remain in use.
For example, if a company spends $10,000 in research for a product
expected to be produced for ten years, it shows the expense as a
deferred charge. Every year, the company will transfer $1,000 from
the asset account to an expense account, until the asset is fully
amortized and eliminated from the balance sheet.
SUMMARY
The function of accounting is to systematically and consistently
record all financial activities. These activities are summarized in the
balance sheet and income statement.
Inflation has a substantial effect on the financial position of a
company. You, as an analyst, must be aware of these effects to obtain
the appropriate conclusions.
The balance sheet is a standard statement that presents the financial
position of a company at a given time. It shows that total assets equal
liabilities plus owners' equity.
On the balance sheet, assets are accounts representing:
n
Property owned by the company
Claims against third parties
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B-13
Asset accounts are classified on the balance sheet according to the

time it takes to realize them and the time when the company intends to
realize them. They are classified as either:
n
Current assets
Non-current assets
Non-current assets are subdivided into:

n
Fixed assets
Other assets
The asset accounts are:

n
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Current assets
Cash
Cash investments
Trade receivables
Inventories
Prepaid expenses
Fixed assets
Property, plant, and equipment
Accumulated depreciation
Other non-current assets
Long-term receivables
Investments
Intangibles
Deferred charges
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B-14
You have just completed the first section of this supplemental section.
the next section, "Liabilities and Net Worth."
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B-15
PROGRESS CHECK B.1
material.
Question 1: The process of systematically and consistently recording all financial

activities is called:
____ a) record keeping.
____ b) bookkeeping.
____ c) financial analysis.
____ d) accounting.
Question 2: What are the two most common statements used to determine the financial
position of a company?
____ a) Balance sheet; source and applications of funds statement
____ b) Source and applications of funds statement; income statement
____ c) Income statement; trial balance
____ d) Balance sheet; income statement
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B-16
ANSWER KEY
Question 1: The process of systematically and consistently recording all financial

activities is called:
d) accounting.
Question 2: What are the two most common statements used to determine the financial
position of a company?
d) Balance sheet; income statement
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B-17
PROGRESS CHECK B.1

(Continued)
Question 3: Indicate whether the following assets are (P) property or (C) claim. The first
one serves as an example.
____
P Vehicles
____ Trade receivables
____ Unfinished products
____ Advances to suppliers
____ Dividends receivable from affiliates
____ Land
____ Stock in other companies
____ Plant machinery
____ Inter-company receivables
____ Raw materials
____ Office building
____ Marketable securities
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B-18
ANSWER KEY
Question 3: Indicate whether the following assets are (P) property or (C) claim. The first
one serves as an example.
P
Vehicles
Trade receivables
Unfinished products
Advances to suppliers
Dividends receivable from affiliates
Land
Stock in other companies
Plant machinery
Inter-company receivables
Raw materials
Office building
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PROGRESS CHECK B.1

(Continued)
Question 4: Match each of the following assets to its definition.

____ Marketable Securities
____ Trade Receivables
____ Prepaid Expenses
____ PPE
____ Investments
____ Deferred Charges
____ Inventory
a) Amounts due from buyers for sales

made by the company on a credit basis
b) Fixed assets that are depreciated on the
balance sheet
c) Capital costs that have not yet been
expensed
d) Liquid short-term investments of cash
for the purpose of earning income in the
form of interest or appreciation
e) Purchased goods intended for
processing and/or resale within one year
from balance sheet date
f) Amounts paid out in advance for goods
or services
g) Assets such as stock in subsidiaries or
non-related companies, real estate not
used for normal business operations,
and other permanent or non-current
holdings
Question 5: Inventories of raw materials used in manufacturing products are classified as

current assets if they are intended for:
____ a) purchase within one year.
____ b) purchase after one year.
____ c) sale within one year.
____ d) sale after one year.
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B-20
ANSWER KEY
Question 4: Match each of the following assets to its definition.

d
Trade Receivables
Prepaid Expenses
PPE
Investments
Deferred Charges
Inventory
a) Amounts due from buyers for sales

made by the company on a credit basis
b) Fixed assets that are depreciated on the
balance sheet
c) Capital costs that have not yet been
expensed
d) Liquid short-term investments of cash
for the purpose of earning income in the
form of interest or appreciation
e) Purchased goods intended for
processing and/or resale within one year
from balance sheet date
f) Amounts paid out in advance for goods
or services
g) Assets such as stock in subsidiaries or
non-related companies, real estate not
used for normal business operations,
and other permanent or non-current
holdings
Question 5: Inventories of raw materials used in manufacturing products are classified as

current assets if they are intended for:
c) sale within one year.
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B-21
PROGRESS CHECK B.1

(Continued)
Question 6: A marketable security is classified as an "other non-current asset" when it:

____ a) matures five days after balance sheet date.
____ b) matures within one year of balance sheet date and is readily marketable.
____ c) is intended to be converted to cash within one year.
____ d) matures one year or more after balance sheet date and is intended to be
converted to cash at maturity.
Question 7: Real estate used in the business of an enterprise is classified as a fixed asset
when:
____ a) the company intends to sell it more than one year from balance sheet date.
____ b) the company does not intend to sell it.
____ c) the company intends to sell it within one year of balance sheet date.
____ d) no buyer can be found.
Question 8: The charge for allocating the cost of a fixed asset over its estimated service
life is called:
____ a) appreciation.
____ b) devaluation.
____ c) depreciation.
____ d) cost of doing business.
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B-22
ANSWER KEY
Question 6: A marketable security is classified as an "other non-current asset" when it:

d) matures one year or more after balance sheet date and is intended to
be converted to cash at maturity.
Question 7: Real estate used in the business of an enterprise is classified as a fixed asset
when:
b) the company does not intend to sell it.
Question 8: The charge for allocating the cost of a fixed asset over its estimated service
life is called:
c) depreciation.
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B-23
PROGRESS CHECK B.1

(Continued)
Question 9: Find four current assets in the list below and mark them with the letter "C."
____ Sales taxes due in 30 days
____ Demand bank deposits
____ Trade receivables due in 60 days
____ Bank loans repayable in four semi-annual installments
____ Raw materials inventories to be used next week
____ Real estate leased to third parties
____ Marketable security maturing in 120 days
____ Production machinery
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B-24
ANSWER KEY
Question 9: Find four current assets in the list below and mark them with the letter "C."
Sales taxes due in 30 days
C
Demand bank deposits
Trade receivables due in 60 days

Bank loans repayable in four semi-annual installments
Raw materials inventories to be used next week

Real estate leased to third parties
Marketable security maturing in 120 days

Production machinery
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B-25
PROGRESS CHECK B.1

(Continued)
Question 10: Fill in the missing values using the assets section of CPT's balance sheet
below.
CPT, INC. DECEMBER 31, 19X1 AND 19X2
ASSETS
CURRENT ASSETS
Cash
Inventory
Prepaid Expenses
19X1
19X2
1,122
1,820
12,204
17,037
1,603
756
1,861
1,200
14,859
20,018
1,922
560
34,542
40,420
22,533
5,821
23,305
7,915
16,712
15,390
Other Assets
Investments
Intangibles
Deferred Charges
422
1,716
744
301
269
387
1,858
1,018
360
359
Total Other Assets
3,452
3,982
54,706
59,792

NON-CURRENT ASSETS
Property, Plant, and Equipment
PPE, Net
TOTAL ASSETS
A) The balance sheet shows total assets of $

in 19X1 and
$
in 19X2. This total is the sum of current, other, and fixed assets.
B) Current assets totaled $
in 19X2. This represents the sum
of cash, marketable securities, trade receivables, (net of the allowance for
uncollectibles), inventories, prepaid expenses, and other current assets.
C) Non-current assets totaled $
in 19X2. This represents the sum
of property, plant, and equipment (PPE), investments, intangibles, and other noncurrent assets.
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B-26
ANSWER KEY
Question 10: Fill in the missing values using the assets section of CPT's balance sheet
below.
ASSETS
CURRENT ASSETS
Cash
Inventory
Prepaid Expenses
19X1
19X2
1,122
1,820
12,204
17,037
1,603
756
1,861
1,200
14,859
20,018
1,922
560
34,542
40,420
22,533
5,821
23,305
7,915
16,712
15,390
Other Assets
Investments
Intangibles
Deferred Charges
422
1,716
744
301
269
387
1,858
1,018
360
359
Total Other Assets
3,452
3,982
54,706
59,792

NON-CURRENT ASSETS
Property, Plant, and Equipment
PPE, Net
TOTAL ASSETS
A) The balance sheet shows total assets of $54,706 in 19X1 and

$ 59,792 in 19X2. This total is the sum of current, other, and fixed assets.
B) Current assets totaled $40,420 in 19X2. This represents the sum of
cash, marketable securities, trade receivables, (net of the allowance for
uncollectibles), inventories, prepaid expenses, and other current assets.
C) Non-current assets totaled $19,372 in 19X2. This represents the sum of
property, plant, and equipment (PPE), investments, intangibles, and other
non-current assets.
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PROGRESS CHECK B.1

(Continued)
Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other.
19X1
19X2
400
768
80
64
_____ Inter-company loans
240
_____ Deferred charges
200
252
_____ Office building
600
900
_____ Legal deposits
160
256
_____ Cash
40
64
_____ Advances to suppliers
80
192
_____ Marketable securities
200
576
_____ Investment in affiliates
200
320
_____ Trade receivables
880
1,472
_____ Accumulated depreciation
(600)
(1,024)
_____ Property and plant
1,600
2,820
320
384
1,200
2,176
F
_____
Transportation equipment
_____ Prepaid expenses
_____ Inventories
_____ Machinery and other equipment
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B-28
ANSWER KEY
Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other.
19X1
19X2
400
768
80
64
Transportation equipment
Prepaid expenses
Inter-company loans
240
Deferred charges
200
252
Office building
600
900
Legal deposits
160
256
Cash
40
64
Advances to suppliers
80
192
200
576
Investment in affiliates
200
320
Trade receivables
880
1,472
Accumulated depreciation
(600)
(1,024)
Property and plant
1,600
2,820
Inventories
320
384
Machinery and other equipment
1,200
2,176
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B-29
PROGRESS CHECK B.1

(Continued)
Question 12: Based on your answers to Question 11, prepare a list of assets for this
company. (Hint: Use the balance sheet model on page B-25 for this
exercise.)
ASSETS
19X1
19X2
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
PPE, Net
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
Total Other Assets
_________
________
CURRENT ASSETS
NON-CURRENT ASSETS
Fixed Assets
Other Assets
TOTAL ASSETS
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B-30
ANSWER KEY
Question 12: Based on your answers to Question 11, prepare a list of assets for this
company. (Hint: Use the balance sheet model on page B-25 for this
exercise.)
ASSETS
19X1
19X2
CURRENT ASSETS
Cash
Marketables Securities
Inventory
Prepaid Expenses
40
200
880
320
80
80
64
576
1,472
384
192
64
1,600
2,752
1,600
1,200
400
600
(600)
2,820
2,176
768
900
(1,024)
3,200
5,640
Inter-Company Loans
Legal Deposits
Deferred Charges
Investment in Affiliates
240
160
200
200
0
256
252
320
Total Other Assets
800
828
5,600
9,220

NON-CURRENT ASSETS
Fixed Assets
Property and Plant
Machinery and Other Equipment
Transportation Equipment
Office Buildings
Accumulated Depreciation
PPE, Net
Other Assets
TOTAL ASSETS
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LIABILITIES AND NET WORTH

Liabilities
Liabilities are the claims of others against the company for resources
supplied to the company. An increase in liabilities reflects an increase
in the resources available to the company and also the need to dispose
of assets to settle the liabilities.
Since most of those resources are in the form of money or of goods
and services, liabilities basically fall into two categories:
Net worth
Claims for money lent, such as bank loans
Claims for credit sales, that is, for goods and services supplied
to the company for later payment
Net worth reflects the wealth invested by shareholders and

accumulated by the company from earnings.
Liabilities
Liabilities are usually classified in the balance sheet in the order of
their realization.
Liability
maturity
The maturity of a liability is the date on which it must be settled.

If you buy something for cash, the liability matures at the time of
purchase and does not appear on the balance sheet. On the other hand,
if the asset is bought on credit, the liability is reflected in the balance
sheet in the order of its maturity.
Not all liabilities mature on the same date. Therefore, liability
maturities can create an uneven outflow of funds.
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Liability
classifications
Based on maturity dates, liabilities are classified in two groups:

n
Current liabilities
Current Liabilities
Mature within
one year
Current liabilities are obligations maturing within one year from

balance sheet date. Current liabilities include:
Due to Banks All interest-paying, short-term bank debts
Accounts Payable All amounts owed to creditors. Since they
usually refer to credit purchases, sometimes they are known as
Trade Payables. Non-trade payables should be excluded for
analysis purposes.
Customer Advances Amounts received from customers as
deposits or down payments on the purchase of goods or services
Accruals Short-term items covering obligations such as payroll
and social security taxes, utilities, sales taxes, etc. This account
reflects costs already charged to income, but not paid.
Taxes Payable Income tax due, but not yet paid
Current Portion of Long-term Debt Installment payments
on long-term loans falling due within one year
Other Current Liabilities Liabilities maturing within one
year which do not fit into any of the above categories
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Mature in more
than one year
Long-term liabilities are obligations maturing more than one year

after balance sheet date. Long-term liabilities include:
Long-term Debt Installment payments on long-term loans
that are due after one year
Deferred Liabilities Long-term accruals. Examples include
income tax on profits earned in one year, but payable in later years
because of favored tax treatment, or a company's obligations for
workers' pensions.
Other Long-term Liabilities Liabilities maturing after one
year which do not fit into any of the above categories
Net Worth (Shareholders' or Stockholders' Equity)

Although this group of accounts is shown on the liability side, it
reflects amounts which the company does not have to pay. It reflects
resources invested by the owners or accumulated by the company
through earnings.
Net worth
accounts
Capital Stock Amount invested in the company by the owners,

based on share par values, not market or liquidation value. Sometimes
we should add to this the amount of paid-in surplus, which reflects
the excess of the amount actually paid for the shares over the face
value of those securities.
Reserves Portions of earnings not available for dividend payments,
either because of legal restrictions, in which case they are called legal
reserves, or as a result of managerial decisions, in which case they are
called free reserves. The term may cause confusion because it may
mislead the reader into thinking there actually is a pool of cash
available to the company which is not always true.
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Retained Earnings or Earned Surplus Past and current earnings

which have not been capitalized or paid out as dividends. Part of the
amount may be capitalized and the remainder paid out in the form
of dividends. Again, this does not mean that cash is available for
this or any other use. Not all companies have profits and, thus,
"Accumulated Losses" may replace "Retained Earnings" on the balance
sheet.
RELATED FINANCIAL STATEMENT CONCEPTS
Off-Balance-Sheet Assets / Liabilities

Assets used
but not owned
Off-Balance-Sheet Items are assets used, but not owned, by the

company, and their related liabilities. This usually includes leased
property on the asset side and the related leasing payments on the
liability side. Companies enter into leasing agreements because they
may be advantageous for tax purposes. Since tax regulations vary from
country to country, so do the relative advantages of leasing / owning.
Contingencies
May be assets
or liabilities
in the future
Contingencies are items which may become assets or liabilities

depending on some future event. For instance, if Company A
sues Company B for breach of contract claiming an indemnity of US$
1 million, there are two possibilities:
n
The court decides for Company B, and no indemnity is paid
The court decides for Company A, and the indemnity must be

paid
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B-35
So, whether Company A has an asset (and Company B a liability)

corresponding to indemnity or not depends on a court decision.
Until the decision is made by the court, the US$ 1 million appears
as a contingent asset in the books of Company A and as a contingent
liability in the books of Company B.
Consolidated Financial Statements

Companies in a
group shown as
a single entity
Consolidated Financial Statements are statements that show all

companies belonging to the same group as if they were a single
company. They are not additions of the figures shown for individual
companies, because all intercompany operations are eliminated. This
means that if Company X and Company Z belong to the same group,
all sales made by Company Z to Company X are eliminated from the
consolidated statements. This is required to prevent double counting
of sales and expenses and of balance sheet accounts such as accounts
receivable and accounts payable.
SUMMARY
Liability accounts represent debts and obligations that a company
incurs to acquire resources for its business.
Liabilities are classified in two groups:
n
Current liabilities
The liability accounts are:

n
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Current liabilities
Due to banks or notes payable to banks
Accounts payable (trade payables)
Customer advances
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B-36
Accruals (accrued items)
Taxes payable
Current portion of long-term debt
Long-term debt
Deferred liabilities
Other long-term liabilities
Net Worth accounts reflect the invested and accumulated wealth of the
stockholders in the enterprise.
Net Worth or Owners' Equity Accounts are:
n
Capital stock
Reserves
Retained earnings (earned surplus)
Analysts need to know how these accounts contribute to the financial

picture of a company. In addition, they need to be aware of offbalance-sheet assets, contingencies, and the need for consolidated
financial statements.
You have now completed the section on "Liabilities and Net Worth."
the section entitled "Income Statement."
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PROGRESS CHECK B.2
material.
Question 13: Liability accounts represent unpaid

and
company incurs to acquire resources for its business.
____ a) debt / expenses
____ b) obligations / revenues
____ c) debt / obligations
____ d) expenses / revenues
Question 14: Resources available to the company are increased by:

____ a) capital investments in the company.
____ b) repayment of the company's borrowings.
____ c) selling inventory on a credit basis.
____ d) shareholders' dividends.
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that the
B-38
ANSWER KEY
Question 13: Liability accounts represent unpaid

and
company incurs to acquire resources for its business.
that the
c) debt / obligations
Question 14: Resources available to the company are increased by:

a) capital investments in the company.
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PROGRESS CHECK B.2

(Continued)
Question 15: Match each of the following liability accounts with its definition.
____ Due Banks
____ Accounts Payable
a) Short-term items covering company

obligations, such as payroll and social
security taxes due
____ Customer Advances
b) Stated amount invested in the enterprise

by the owners
____ Accruals
c) Interest paying short-term debts
____ Taxes Payable
d) Amounts received for production of

goods or provision of services not yet
made
____ Capital Stock

____ Retained Earnings
____ Additional Paid-in Capital
e) Amounts owed to trade suppliers for the

purchase of inventories, raw materials,
etc.
f) Income taxes due, but not yet paid
g) Difference between issue value and par
value of a common stock
h) Cumulative past earnings held within the
firm but not yet capitalized
Question 16: Customer advances are classified as current liabilities when they mature:
____ a) after one year of balance sheet date.
____ b) within one year of balance sheet date.
____ c) after two years of balance sheet date.
____ d) between one and two years.
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ANSWER KEY
Question 15: Match each of the following liability accounts with its definition.
c
Due Banks
a) Short-term items covering company

obligations, such as payroll and social
security taxes due
Accounts Payable
Customer Advances
b) Stated amount invested in the enterprise

by the owners
Accruals
c) Interest paying short-term debts
Taxes Payable
Capital Stock
d) Amounts received for production of

goods or provision of services not yet
made
Retained Earnings
Additional Paid-in Capital
e) Amounts owed to trade suppliers for the

purchase of inventories, raw materials,
etc.
f) Income taxes due, but not yet paid
g) Difference between issue value and par
value of a common stock
h) Cumulative past earnings held within the
firm but not yet capitalized
Question 16: Customer advances are classified as current liabilities when they mature:
b) within one year of balance sheet date.
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PROGRESS CHECK B.2

(Continued)
Question 17: A loan repayable in twelve semi-annual installments is a

loan.
Since the first two installments mature within one year, they should be
classified as
.
____ a) short-term / current
____ b) long-term / current
____ c) short-term / long
____ d) long-term / long
Question 18: A loan maturing in five years is classified as long-term debt. After the fourth
year, it will be:
____ a) forgiven.
____ b) paid off.
____ c) included within current liabilities.
____ d) reclassified as shareholders' equity (net worth).
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ANSWER KEY
Question 17: A loan repayable in twelve semi-annual installments is a

loan.
Since the first two installments mature within one year, they should be
classified as
.
b) long-term / current
Question 18: A loan maturing in five years is classified as long-term debt. After the fourth
year, it will be:
c) included within current liabilities.
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PROGRESS CHECK B.2

(Continued)
Question 19: Using the liability section of the balance sheet below, fill in the missing
values.
19X1
19X2
Due to Banks
Trade Payables
Customer Advances
Accruals
Taxes Payable
Current Portion of Long-term Debt
12,522
7,341
1,421
990
456
558
1,845
31,916
13,020
2,388
1,546
1,172
378
2,110
25,133
52,530
8,845
1,863
7,355
2,289
10,708
9,644
35,841
62,174
10,000
1,667
7,198
10,000
2,046
11,172
TOTAL NET WORTH
18,865
23,218
54,706
85,392
CURRENT LIABILITIES
Long-term Debt
Long-term Deferred Liabilities
TOTAL LIABILITIES
NET WORTH
Capital Stock
Capital Reserves
Retained Earnings
A) Liabilities and Net Worth in 19X1 were $
and $
, respectively.
B) Current Liabilities totaled $

in 19X2. This represents the sum of Due to
Banks, Trade Payables, Customer Advances, Accruals, Taxes Payable, Other Current
Liabilities, and the Current Portion of Long-term Debt.
C) Long-term Liabilities totaled $
in 19X1. This represents the sum of Longterm Debt and Long-term Deferred Liabilities.
D) Stockholder's Equity (Net Worth) totaled $
in 19X2. This represents the
sum of Capital Stock, Capital Reserves, and Retained Earnings.
E) Liabilities and Net Worth combined totaled $
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in 19X2.
B-44
ANSWER KEY
Question 19: Using the liability section of the balance sheet below, fill in the missing
values.
A) Liabilities and Net Worth in 19X1 were $35,841 and $18,865 , respectively.
B) Current Liabilities totaled $52,530 in 19X2. This represents the sum of Due to
Banks, Trade Payables, Customer Advances, Accruals, Taxes Payable, Other Current
Liabilities, and the Current Portion of Long-term Debt.
C) Long-term Liabilities totaled $10,708 in 19X1. This represents the sum of Longterm Debt and Long-term Deferred Liabilities.
D) Stockholder's Equity (Net Worth) totaled $23,218 in 19X2. This represents the sum
of Capital Stock, Capital Reserves, and Retained Earnings.
E) Liabilities and Net Worth combined totaled $85,392 in 19X2.
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PROGRESS CHECK B.2

(Continued)
Question 20: Classify the following liability accounts as either (C) Current, (L) Longterm, or (S) Shareholders' Equity (Net Worth).
19X1
19X2
176
____ Capital stock
800
1,260
____ Dividends payable
200
201
____ Fixed asset loan maturing in 3 years
400
512
____ Due to suppliers
480
640
____ Capital reserves
600
1,300
____ Payroll accruals
120
247
____ Income taxes due
240
408
____ Shareholders' loans without agreed maturity
400
168
____ Utility bills
120
72
____ Retained earnings
400
960
____ Other accruals
240
456
____ Bank loans maturing within 60 days
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B-46
ANSWER KEY
Question 20: Classify the following liability accounts as either (C) Current, (L) Longterm, or (S) Shareholders' Equity (Net Worth).
19X1
19X2
176
Bank loans maturing within 60 days
Capital stock
800
1,260
Dividends payable
200
201
Fixed asset loan maturing in 3 years
400
512
Due to suppliers
480
640
Capital reserves
600
1,300
Payroll accruals
120
247
Income taxes due
240
408
Shareholders' loans without agreed maturity
400
168
Utility bills
120
72
Retained earnings
400
960
Other accruals
240
456
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PROGRESS CHECK B.2

(Continued)
Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net
Worth accounts for this company. (Hint: Follow the balance sheet model
from Question 19.)
19X1
19X2
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_________
________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_____________________________________
_________
________
_________
________
CURRENT LIABILITIES
TOTAL LIABILITIES
NET WORTH
TOTAL NET WORTH

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ANSWER KEY
Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net
Worth accounts for this company. (Hint: Follow the balance sheet model
from Question 19.)
19X1
19X2
CURRENT LIABILITIES
Bank Loans Maturing Within 60 Days
Due to Suppliers
Payroll Accruals
Utility Bills
Other Accruals
Income Tax Due
Dividends Payable
--480
120
120
240
240
200
176
640
247
72
456
408
201
1,400
2,200
Fixed Asset Loan Maturing in Three Years

Shareholders Loans Without Agreed Maturity
400
400
512
168
800
680
2,200
2,880
800
600
400
1,2600
1,300
960
TOTAL NET WORTH
1,800
3,520
4,000
6,400

TOTAL LIABILITIES
NET WORTH
Capital Stock
Capital Reserves
Retained Earnings
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B-49
INCOME STATEMENT
The income statement shows the results of the operations of a
company by deducting expenses from matching income for a
given period. It is sometimes called a profit and loss statement.
The structure of the income statement reflects the following equation:
Net Income = Revenues Expenses
Positive / Negative Results

When expenses are lower than income, results are positive and the
company is said to have a profit. If income is lower than expenses,
results are negative and the company is said to have a loss.
Below is a sample income statement for CPT, Inc.
CPT, INC.
Income Statement
Years ended December 31, 19X1 and 19X2
19X1
19X2
Net Sales
Cost of Goods Sold
66,540
43,715
85,362
60,077
Gross Profit
Selling, General Admin. Expenses
22,825
10,424
25,285
12,780
Operating Profit
12,401
12,505
1,988
4,255
-405
2,094
5,694
-904
5,753
3,813
1,640
0
1,088
1,440
4,113
4,165
Depreciation
Financial Expense
+ Other Income, Net
Income Tax
+ Extraordinary Items
Net Income
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Income Statement Structure

The income statement is usually prepared in a single column. The top
line shows net sales. In the following lines, other revenues are added
and expenses subtracted, until a net income figure is reached. The net
income figure is commonly referred to as the bottom line.
In some income statements, the last line shows earnings per share,
which is determined by dividing net income by the number of stock
shares outstanding. The general structure is:
Net Sales (Net of Any Returns, Discounts, or Sales Taxes)
Minus: Cost of Goods Sold (CGS)
=
Gross Profit
Minus: Operating Expenses
Selling
General
Administrative
Operating Profit
Minus: Depreciation
Minus: Financial Expense (Net of Financial Income)
Plus: Other Income (Net of Other Expense)
Pretax Income
Minus: Income Tax
Plus / Minus: Extraordinary Items
Net Income (After-tax Income)
This general structure is universal, although sometimes the gross

margin may be computed after deduction of selling, general, and
administrative expenses. The nomenclature, above, may vary as
well, e.g. cost of goods sold ( CGS ) is sometimes called cost of sales.
However, the basic concepts remain the same. Revenues are listed
first and totaled to determine net sales; then expenses are deducted
to determine net income or loss. Let's take a closer look.
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Income Statement Accounts

Net Sales Sales revenues net of returns, discounts, and sales taxes.
Most companies sell on credit, and accrual basis accounting principles
require them to recognize the sale when it is made, not when the cash
is received. As a consequence, in those cases, net sales always reflect
uncollected (unrealized) sales in the same amount as shown in
accounts receivable.
Cost of Goods Sold or Cost of Sales For a service company, this
basically includes labor; for a commercial company, it also includes
the cost of goods bought for resale (plus insurance and freight); for an
industrial company, it also includes materials and processing costs.
Selling, General, and Administrative Expenses Expenditures
related to selling, marketing, and administrative activities. They
include salaries of sales personnel, advertising, telephone, etc.
Depreciation We have already discussed depreciation as it relates
to fixed assets. We should stress that since depreciation is a non-cash
charge, it does not involve an actual outflow of funds. However, since
it is reflected in pretax income, it does affect the income tax bill.
In certain cases, accelerated depreciation is allowed. This means that
the asset will be (a) depreciated over a term shorter than its useful life,
or (b) depreciated at higher rates in the early years of its life and lower
rates in the later years.
Since depreciation reduces pretax income, higher initial depreciation
means lower income tax during the first years an asset is used. Of
course, this is compensated by higher income tax during later years.
As a consequence, the real advantage to the company is that income
tax payments are partially deferred. Accelerated depreciation is one of
the factors that affect deferred liabilities.
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Financial Expense (Interest Expense) Interest and commissions

on loans and credit purchases. This account is generally shown net
of financial income, such as interest earned on cash investments and
credit sales. However, if financial income is material, it should be
shown separately.
Other Income Items that cannot be classified within any of the
above accounts. The amount is usually low and shown net of other
expense.
Income Tax Amount of income tax owed by the company on its
profits for the period
Extraordinary Items Items, such as property sales, segregated
to show that they are not recurrent
Net Income Amount left after all expenses are deducted from
revenues. This amount, less dividends paid, will be reflected in the net
worth section of the balance sheet as a change in retained earnings.
Accounting Principles
Financial statement preparation follows several accounting principles
to achieve precision and clarity. The concepts have special relevance
to the income statement. These principles include:
Cost principle
Realization principle
Matching principle
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Cost Principle
All items
recorded at
original cost
The cost principle states that all items will be recorded at original cost
(the amount paid for them). This principle ensures that all companies
will be using cost value, not market value, when presenting their
statements.
This may sound strange at first, because market value is very important
when determining the value of a business. However, there is no
objective way for all companies to calculate the current market value
of their properties. The valuation depends on which appraisal method
is used.
To eliminate subjectivity and ensure comparability for all financial
statements, the accounting profession has established cost instead of
market value as the standard to follow. Market value information,
along with an explanation of the methodology used, may also be
presented with a financial statement. In this way, the investor will have
the information needed to make a wise investment decision.
The cost principle implicitly recognizes another fundamental
accounting assumption: accounts are prepared on the basis that the
company is a going concern. As such, current market value is less
relevant since the company has no interest in liquidating its assets.
Having said this, however, the accounting profession does recognize
that if the difference in the value of fixed assets valued at cost is too
far removed from reality because of accumulated inflation, then a
revaluation of these fixed assets may be done. The revaluation process
must follow strict accounting rules which compensate for
accumulated depreciation in addition to inflation. In this way, the value
of fixed assets on the balance sheet may be updated on an infrequent
basis.
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B-54
Realization Principle
Recognize
revenue when
earned and
expenses when
incurred
The realization principle states that revenues should be recorded when

earned, and expenses recorded when incurred; assets should be
recorded when owned, and liabilities should be recorded when owed.
With this principle, we recognize revenue as we earn it, even though
we might not have received any payment. At the same time, we must
recognize expenses as we incur them, even though we might not have
made any payment.
This method provides a more realistic picture of the business since
it shows everything owned and owed. The realization principle
helps prevent the intentional delay of payments and acceleration
of receipts for the purpose of manipulating financial results.
The quick reader will also realize another effect of the realization
principle. Net income does not equal cash. A company may have
a good net income on paper, but very little money in the bank. For
example, the cash from sales has not yet been received since sales
were made granting generous credit terms. In an opposite situation,
a company may have little or no profit because it is liquidating
inventory at cost or near cost, yet the company has a strong cash
position as a result of this liquidation.
Matching Principle
Revenues
recognized in
same period
as expenses
The matching principle states that expenses incurred in generating a

given income must be recognized (recorded) in the same accounting
period as the revenue. When a revenue is earned, there are always
certain expenses associated with it. We must record those expenses at
the same time the revenue is recognized. That is, we match the
revenues with the corresponding expenses. Again, this principle is
intended to prevent possible manipulation of results.
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SUMMARY
The income statement (or profit and loss statement) can be
summarized by this equation:
Net Income = Revenue Expenses
Simply put:
n
If income exceeds expenses, a profit results.
If expenses exceed income, a loss results.
The income statement structure begins with net sales and other
revenues listed first. Expenses are then deducted to determine net
income or loss.
Financial statement preparation follows several accounting principles
that have special relevance to the income statement. These principles
include:
Cost principle
Matching principle
You have now completed the final section of Appendix B. Please complete the following
Progress Check to make sure you understand the concepts presented in this section.
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PROGRESS CHECK B.3
material.
Question 22: Indicate whether the following accounts are (I) income or (E) expense.
____ Payroll
____ Product sales
____ Cost of goods sold
____ Sales commissions
____ Building depreciation
____ Utilities
____ Investment profits
____ Cost of services
____ Selling of goods
____ Dividends received
____ Provision for income tax
____ Cost of maintenance
Question 23: Costs and expenses are deducted from revenues in the income statement to
determine results. Positive results are called
; negative results
are called
.
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B-58
ANSWER KEY
Question 22: Indicate whether the following accounts are (I) income or (E) expense.
E
Payroll
Product sales
Cost of goods sold
Sales commissions
Building depreciation
Utilities
Investment profits
Cost of services
Selling of goods
Dividends received
Provision for income tax
Cost of maintenance
Question 23: Costs and expenses are deducted from revenues in the income statement to
determine results. Positive results are called profits ; negative results are
called losses .
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B-59
PROGRESS CHECK B.3

(Continued)
Question 24: Gross sales on the income statement include:

____ a) cash sales only.
____ b) cash and credit sales.
____ c) credit sales only.
____ d) collected sales only.
Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash
account. Credit sales increase:
____ a) marketable securities.
____ b) inventory.
____ c) trade receivables.
____ d) deferred credits.
Question 26: The income statement normally shows revenues, expenditures, and costs:
____ a) before receipt or payment.
____ b) only after they have been received or paid.
____ c) whether or not they have been received or paid.
____ d) upon receipt or payment.
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ANSWER KEY
Question 24: Gross sales on the income statement include:

b) cash and credit sales.
Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash
account. Credit sales increase:
c) trade receivables.
Question 26: The income statement normally shows revenues, expenditures, and costs:
c) whether or not they have been received or paid.
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B-61
PROGRESS CHECK B.3

(Continued)
Question 27: Match each of the following revenue and expense accounts to its definition.
____ Cost of Goods Sold
a) Sum of revenues minus expenses
____ Selling, General, and Adm.
b) Non-recurring gains or losses that result

from activities that are not part of the
normal operations of the business
____ Depreciation
____ Financial Expense
____ Extraordinary Gains / Losses
____ Net Income
c) Interest expense on interest-paying debt

d) Non-cash charge that reduces the book
value of the plant or equipment every
year
e) Expenses incurred such as management
salaries, cost of advertising, telephones,
etc.
f) Cost of raw materials, labor, and
overhead expenses attributed to the
processing of goods
____ a) The income statement only shows all income and expense received
and paid during the period.
____ b) Cost of Goods Sold includes expenditures such as direct labor
expenses, raw materials, and interest.
____ c) Certain asset and liability accounts are related to the income
statement. For instance, credit sales are related to trade receivables;
financial expense is related to bank loans.
____ d) Selling, General, and Administrative expenses represent expenditures
such as advertising, sales commissions, and telephone.
____ e) Extraordinary gains result from normal business operations.
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ANSWER KEY
Question 27: Match each of the following revenue and expense accounts to its definition.
f
Cost of Goods Sold
a) Sum of revenues minus expenses
Selling, General, and Adm.
Depreciation
b) Non-recurring gains or losses that result

from activities that are not part of the
normal operations of the business
Financial Expense
Extraordinary Gains / Losses
Net Income
c) Interest expense on interest-paying debt

d) Non-cash charge that reduces the book
value of the plant or equipment every
year
e) Expenses incurred such as management
salaries, cost of advertising, telephones,
etc.
f) Cost of raw materials, labor, and
overhead expenses attributed to the
processing of goods
F
a) The income statement only shows all income and expense received and
paid during the period.
b) Cost of Goods Sold includes expenditures such as direct labor expenses,

raw materials, and interest.
c) Certain asset and liability accounts are related to the income statement.
For instance, credit sales are related to trade receivables; financial
expense is related to bank loans.
d) Selling, General, and Administrative expenses represent expenditures

such as advertising, sales commissions, and telephone.
e) Extraordinary gains result from normal business operations.
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B-63
PROGRESS CHECK B.3

(Continued)
Question 29: Refer to the Income Statement for CPT, Inc. below and complete the
following questions:
A) Net Sales totaled $
in 19X1 and $
in 19X2.
B) Gross profit is the difference between:

____ a) Net Sales and Cost of Goods Sold.
____ b) Net Sales and Selling, General, and Administration Expense.
____ c) Operating Profit and Financial Expense.
C) Net Income amounted to $
in 19X1 and to $
the net result of Revenues less Expenses.
in 19X2. This is
Sample Income Statement

CPT, INC.
Income Statement Years ended December 31, 19X1 and 19X2
19X1
19X2
Net Sales
Cost of Goods Sold
66,540
43,715
85,362
60,077
Gross Profit
Selling, General, Admin. Expenses
22,825
10,424
25,285
12,780
Operating Profit
12,401
12,505
1,988
4,255
-405
2,094
5,694
-904
5,753
3,813
1,640
0
1,088
1,440
4,113
4,165
Depreciation
Financial Expense
+ Other Income, Net
Income Tax
+ Extraordinary Items
Net Income
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ANSWER KEY
Question 29: Refer to the Income Statement for CPT, Inc. below and complete the
following questions:
A) Net Sales totaled $66,540 in 19X1 and $85,362 in 19X2.
B) Gross profit is the difference between:
a) Net Sales and Cost of Goods Sold.
C) Net Income amounted to $4,113 in 19X1 and to $85,362 in 19X2. This is
the net result of Revenues less Expenses.
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B-65
PROGRESS CHECK B.3

(Continued)
Question 30: Fill in the blanks and compute net income or loss.
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Net Sales
Cost of Goods Sold
$ 1,300
550
Gross Profit
Operating Profit
Depreciation
Financial Expense
Other Income, Net

Provision for Income Tax
Net Income
250
100
200
50
45
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ANSWER KEY
Question 30: Fill in the blanks and compute net income or loss.
Net Sales
Cost of Goods Sold
$ 1,300
550
Gross Profit
Operating Profit
Depreciation
Financial Expense
Other Income, Net
500
100
200
50

Provision for Income Tax
150
45
Net Income
105
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750
250
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B-67
PROGRESS CHECK B.3

(Continued)
Question 31: Prepare an income statement based on the structure shown in Question 30.
Use the data listed below:
19X1
Administrative Expense
Net Sales
Selling Expense
Extraordinary Gain
General Expense
Cost of Goods Sold
Net Income
Income Tax
Depreciation
Net Financial Expense
Other Income
120
3,000
290
180
55
1,400
678
207
100
350
20
19X2
276
5,100
514
0
74
2,700
784
321
105
357
31
19X1
19X2
_________
________
_______________________________
_________
________
Gross Profit
_______________________________
_________
_________
________
________
Operating Profit
_______________________________
_________
________
_______________________________
_________
________
_______________________________
_________
________
Earnings Before Income Tax

_______________________________
_________
________
_______________________________
_________
________
_________
________
Net Sales
Net Income
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ANSWER KEY
Question 31: Prepare an income statement based on the structure shown in Question 30.
Use the data listed below:
19X1
Administrative Expense
Net Sales
Selling Expense
Extraordinary Gain
General Expense
Cost of Goods Sold
Net Income
Income Tax
Depreciation
Other Income
120
3,000
290
180
55
1,400
678
207
100
350
20
19X2
276
5,100
514
0
74
2,700
784
321
105
357
31
19X1
19X2
Net Sales
Cost of Goods Sold
3,000
1,400
5,100
2,700
Gross Profit
1,600
465
2,400
864
Operating Profit
Depreciation
Other Income, Net
1,135
100
350
20
1,536
105
357
31
Earnings Before Income Tax

Income Tax
+ Extraordinary Gain
705
207
180
1,105
321
0
678
784
Net Income
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PROGRESS CHECK B.3

(Continued)
Question 32: Match the accounting principle with its purpose.

____ Cost principle
a) Prevents the delay of payments and

acceleration of receipts to enhance
financial statements
____ Realization principle
b) Assures a true picture of a companys

revenues
____ Matching principle
c) Avoids an incorrect valuation of assets
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ANSWER KEY
Question 32: Match the accounting principle with its purpose.

c
Cost principle
a) Prevents the delay of payments and

acceleration of receipts to enhance
financial statements
b) Assures a true picture of a companys

revenues
Matching principle
c) Avoids an incorrect valuation of assets
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APPENDIX C
GLOSSARY
Accounting
System for recording and reporting transactions
Accounts
Payable
Amounts owed by a company
Accounts
Receivable
Amounts owed to a company
Acid Test
(Quick Asset Ratio) The sum of cash plus near current marketable
securities plus receivables divided by current liabilities; liquidity
ratio
Asset
Property of a company or a claim against third parties
Asset Turnover
Ratio
Ratio obtained by dividing net sales by average total assets; it is an

indicator of operating efficiency
Balance Sheet
Statement that provides a financial picture of a company at a given

time and summarizes the fundamental accounting equation of
assets = liabilities + owners' equity
Capital Stock
Balance sheet account showing the amount that shareholders

contributed in exchange for stock
Collection
Period
(Days Receivable) Operating ratio expressing in days the average

time taken to turn over trade receivables from the balance sheet
within the annual credit sales
Common Stock
Shares that confer voting rights to owners but not preferential

treatment with regard to dividends
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GLOSSARY
Consolidated
Financial
Statement
Statement that aggregates data for several companies with

significant inter-company ownership that are members of the same
business group
Contingency
Potential asset or liability that depends on future events to become

actual
Current Assets
Assets that are to be realized or consumed within one year
Current
Indebtedness
Ratio
Indebtedness ratio obtained by dividing current liabilities by net

worth (owners' equity)
Current
Liabilities
Liabilities to be paid within one year
Current Ratio
Liquidity ratio obtained by dividing current assets by current

liabilities
Days Inventory
(Inventory Period) Operating ratio obtained by dividing inventory

turnover by 360; expresses in days the average time taken to turn
over inventory from the balance sheet within the annual cost of
goods sold
Days Receivable
See "Collection Period"
Deferred
Charges
Expenditures carried forward to be recognized as costs in future

years
Depreciation
Non-cash charge on the income statement that reflects a cost

allocation (made during the useful life of the asset) for plant and
equipment expenditures
Earned Surplus
(Retained Earnings) Net income accumulated over time less all

dividends paid to stockholders; owners' equity account
Financial Credits
Interest-bearing obligations that originate from a need for

additional funds for operations
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GLOSSARY
C-3
Financial Ratio
Index or percentage that is derived from dividing one balance sheet

or income statement account by another balance sheet or income
statement account
Financial
Statement
Summary of accounting records that consists primarily of the

balance sheet and income statement
Fixed Asset
Asset which a company does not intend to realize property,

plant, and equipment
Fixed Assets to
Net Worth Ratio
Ratio obtained by dividing fixed assets by net worth; measures

the amount of fixed assets covered by own resources
Funds
All measurable assets that are available to the company for use
in its operation
Horizontal
Analysis
Technique used to track individual account growth rates from

one period to another
Income
Statement
Summary of a company's revenues and expenses for a given period
Indebtedness
Ratio
(Leverage) Result of dividing liabilities by net worth to measure the

relationship between outside capital and owners' equity; also may be
called capital structure ratio or solvency ratio
Indexation
Technique used in an inflationary economy to reduce the effect

of price differences between time of occurrence and time of
recording
Intangibles
Assets that constitute nonphysical property, such as copyrights,

patents, licensing rights, and preoperating expenses
Inventory
Goods purchased or manufactured by a company and kept for

sale or use as inputs to its products a current asset account
Inventory Period
See "Days Inventory"
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GLOSSARY
Inventory
Turnover
Operating ratio obtained by dividing cost of goods sold for a period

by the average inventory for the same period; expresses
in times per year the average time taken to consume inventory
Invested Capital
Amount of resources invested and paid in by the shareholders in the

company
Investments
Long-term assets not used in operations, such as shares in other

companies
Legal Deposits
Deposit of funds in a bank or government agency to cover the

cost of certain business transactions
Leverage
See "Indebtedness Ratio"
Liability
Claims against a company
Liquidity
Ability of an asset to be readily realized
Liquidity Ratio
Financial index that measures the ability of the enterprise to meet

its short-term financial obligations in a timely manner without
realizing fixed assets; indicates the relationship between current
assets and current liabilities
Loans to
Affiliates
(Inter-company Receivables) Loans made to affiliated companies;

usually classified as non-current assets because they are usually
disguised forms of long-term funding
Long-term
Indebtedness
Ratio
Ratio obtained by dividing long-term liabilities by net worth
Long-term
Receivables
Obligations due from customers or others that mature after

one year
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GLOSSARY
C-5
Margin Analysis
Technique for income statement analysis that breaks down

individual revenue and expense accounts into percentages of
net sales
Marketable
Security
Money market securities held as very short term investments for

the purpose of investing excess funds to maximize return on assets
Monetary
Correction
Accounting techniques utilized in high inflationary environments to

reflect the changes in the purchasing power of a currency
Monetary Items
Assets and liabilities realizable or payable in currency that can

generate gains or losses resulting from inflation or foreign
exchange transactions
Net Worth
(Owners' Equity, Shareholders' Equity) Balance sheet account

that reflects the invested wealth and accumulated earnings; includes
paid-in capital, retained earnings, and reserves
Non-current
Assets
Fixed assets, long-term assets, and deferred charges
Non-current
Liabilities
Debts and obligations that mature more than one year from the
balance sheet date
Off-balancesheet Assets
Assets, such as leased property, that are used by a company

but not shown on the balance sheet
Off-balancesheet Liabilities
Debts, such as those incurred in connection with leasing

agreements, that are not shown on the balance sheet
Operating
Credits
Liabilities originating in trade operations
Operating Ratio
Type of ratio that measures the efficiency and effectiveness of

a company's utilization of its assets
Owners' Equity
See "Net Worth"
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GLOSSARY
Paid-in Capital
(Permanent Capital) Amount paid by investors in exchange for

a company's stock; an owners' equity account
Paid-in Surplus
Excess of the actual amount of capital paid to the company by

shareholders over the par value of purchased shares an owners'
equity account
Payables
Turnover Ratio
Operating ratio indicating the number of times payables are rotated

during the period within a firm's annual purchases or
cost of goods sold; obtained by dividing total purchases by
trade payables
Permanent
Capital
See "Paid-in Capital"
PPE
Abbreviation for property, plant, and equipment
Preferred Stock
Shares that grant owners priority on receiving dividends but

generally do not grant voting rights an owners' equity account
Prepaid
Expenses
Amounts paid in advance that are carried forward to be recognized

as costs during the year after balance sheet date
Profit on Sales
(Return on Sales) Profitability ratio, expressed in percentage terms,

obtained by dividing the annual profit (net income) by
the net sales
Profitability
Ratio
Any of the ratios used to measure the ability of a company to

generate profits
Quick Asset
Ratio
See "Acid Test"
Realizing
Converting an asset into cash
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GLOSSARY
C-7
Receivables
Turnover Ratio
Operating ratio expressing in times per year the average time taken
to collect receivables from the balance sheet within the annual net
credit sales; obtained by dividing credit sales by
trade receivables
Reserves
Portions of retained earnings set aside voluntarily or in compliance

with legal requirements
Retained
Earnings
See "Earned Surplus"
Return on
Assets
Profitability ratio, expressed in percentage terms, obtained by

dividing the annual profit (net income) by average total assets
Return on
Capital
(Return on Equity) Profitability ratio, expressed in percentage

terms, obtained by dividing the annual profit (net income) by
average net worth
Return on Equity
See "Return on Capital"
Return on Sales
See "Profit on Sales"
Revaluation
Updating of asset values based on appraisal reports
Shareholders'
Equity
See "Net Worth"
Tangible Net
Worth
Net worth less intangible assets
Third Party
Capital
Total owed to suppliers and financial institutions
Total
Indebtedness
Ratio
Ratio obtained by dividing total liabilities by owners' equity

(net worth)
Trade
Receivables
Accounts receivable from customers
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GLOSSARY
Vertical Analysis
Technique that breaks down individual assets, liabilities, equities,

and expense accounts into percentages for comparison purposes;
analysis of the financial statements of a single company or across
several companies for a particular period
Working Capital
Excess of current assets over current liabilities
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Index
INDEX
A
Accounting
1-11-6, 1-9, 1-10, 1-12, 1-16, 1-17, 1-25, 1-27, 1-28, 1-32,
1-35, 2-1, 2-3, 2-31, 3-9, 5-10, 6-13, 8-19, 8-42, 8-43, B-1
B-3, B-6, B-10, B-12, B-51B-55,
Accounts Payable
1-6, 1-26, 1-28, 2-28, 2-44, 6-23, 6-26, 8-12, B-32, B-35,
Accounts
Receivable
1-26, 1-28, 1-31, 4-5, 6-3, 6-6, 8-12, 8-45, B-5, B-6, B-9, B-35,
B-51, C-28, C-44
Acid Test
4-1, 4-3, 4-64-8, 7-21
Asset
1-4, 1-7, 1-9, 1-10, 1-121-17, 1-25, 1-26, 1-281-32, 1-35, 212-7, 2-10, 2-11, 2-262-30, 2-33, 3-2, 3-10, 3-11, 3-25, 326, 3-28, 4-1, 4-3, 4-174-19, 5-15-10, 5-12, 5-13, 5-15, 6-1,
6-33, 6-34, 7-3, 7-4, 7-117-14, 8-12, 8-41, 8-42, B-5B-13,
B-31, B-34, B-35, B-51, B-53, B-54,
Asset Turnover
Ratio
1-11, 1-16, 4-3, 4-5, 4-8, 6-1, 6-2, 6-33, 6-34,
B
Balance Sheet
1-51-8, 1-101-16, 1-25, 1-26, 1-29, 1-311-33, 1-35,

2-3, 2-10, 2-262-29, 2-32, 4-4, 4-7, 4-8, 4-17, 5-3, 5-4, 56, 5-9, 5-10, 5-14,6-2, 6-56-7, 6-13, 6-15, 6-16, 6-26, 634, 7-5, 7-11, 8-28-4, 8-12, 8-408-43, 8-45, 8-47,
B-1, B-2, B-4B-8, B-12, B-13, B-31B-35, B-52, B-53,
C
Capital Stock
1-6, 8-5, B-5, B-33, B-36
Collection Period
6-5, 6-6
Common Stock
8-12
Consolidated
Financial Statement
1-11, 5-9, B-35, B-36
Contingency
B-34, B-36
Current Assets
1-6, 1-8, 2-32-7, 2-10, 2-28, 3-24, 3-25, 3-28, 4-1, 4-34-8,
4-174-19, 5-12, 5-13, 6-1, 6-2, 6-13, 7-21, 8-12, 8-44
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INDEX
C (Continued)
Current
Indebtedness Ratio
5-11, 5-12, 5-15
Current Liabilities
1-6, 1-8, 2-32-5, 2-7, 2-10, 2-11, 2-28, 3-11, 4-1, 4-347, 4-174-19, 5-6, 5-115-13, 5-15, 7-21, 8-12, 8-44,
Current Ratio
2-4, 4-1, 4-34-8, 4-174-19, 6-1,
D
Days Inventory
4-8, 6-1, 6-2, 6-7, 6-136-18, 6-28, 7-21
Days Receivable
4-8, 6-1, 6-2, 6-46-7, 6-16, 6-26, 6-28, 7-21
Deferred Charges
3-10,B-5, B-12, B-13
Depreciation
1-6, 2-30, 2-31, 2-44, 3-12, 5-14, 8-12, 8-41, 8-44, 8-45,
B-5, B-10, B-12, B-13, B-49B-51, B-53,
E
Earned Surplus
B-34, B-36
F
Financial Credits
2-8, 2-9, 2-11
Financial Ratio
1-34,3-9, 3-28, 4-14-3, 4-19, 5-1, 5-16, 6-1, 6-34, 7-1, 711, 7-15, 7-21, 8-2, 8-3, 8-9, 8-39, 8-78
Financial Statement
1-4, 1-5, 1-91-11, 1-17, 1-25, 1-26, 1-28, 1-291-32, 1-35,

1-36, 2-1, 2-33, 3-13-4, 3-9, 3-19, 3-28, 4-1, 6-3, 8-18-3,
8-98-12, 8-39, 8-44, 8-46, B-1-B-4, B-7, B-11, B-34
B-36, B-52, B-53, B-55
Fixed Asset
1-6, 1-10, 1-12, 1-13, 1-16, 1-28, 1-30, 1-33, 2-3, 2-6, 2-7, 230, 2-33, 3-25, 4-174-19, 5-1, 5-35-8, 5-12, 5-13, 5-15,
5-16, 6-34, 7-13, 7-14, 8-1, 8-3, 8-12, 8-408-42, B-7, B-10,
B-13, B-51,B-53
Fixed Assets to
Net Worth Ratio
5-1, 5-13, 5-14, 5-16, 5-17
Funds
1-10, 1-11, 1-26, 1-33, 2-1, 2-4, 2-6, 2-7, 2-11, 2-262-33,
3-9, 3-11, 3-13, 4-6, 5-13, 5-14, 5-16, 6-1, 6-27, 8-18-3,
8-43, B-7, B-8, B-31, B-51,
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INDEX
I-3
H
Horizontal Analysis
3-1, 3-9, 3-13, 3-253-28
I
Income Statement
1-5, 1-6, 1-8, 1-26, 1-27, 1-29, 1-31, 1-33, 1-35, 2-9, 2-29, 230, 2-32, 2-33, 3-1, 3-10, 3-12, 3-13, 3-28, 4-8, 6-2, 6-3, 613, 6-16, 6-25, 8-2, 8-3, 8-5, 8-13, 8-40, 8-41, 8-45, 8-48, B1, B-2, B-4, B-10, B-12, B-36, B-4952, B-55
Indebtedness Ratio
5-1, 5-2, 5-7, 5-11, 5-12, 7-21
Indexation
1-9, 1-28, 3-2, 3-9
Intangibles
1-4, 1-9, 1-131-15, 1-17, 1-25, 2-30, 5-6, 5-7, B-5, B-11,
B-13
Inventory
1-6, 1-11, 1-12, 2-10, 2-30, 2-31, 2-44, 3-4, 3-10, 4-4, 4-5, 47, 4-8 6-1, 6-2, 6-136-18, 6-28, 7-11, 8-3, 8-10, 8-12,
8-44, B-5, B-54
Inventory Turnover
2-10, 6-1, 6-2, 6-7, 6-136-15, 6-17, 6-18, 8-45, 8-46
Investments
1-6, 1-28, 2-6, 2-29, 5-13, 7-1, 7-4, 7-5, B-5, B-7, B-9, B-11,
B-13, B-52, B-53
L
Leverage
1-13, 2-9, 4-2, 4-19, 5-15-13, 5-155-17, 6-34, 7-117-15
Liability
1-9, 1-12, 1-13, 1-15, 2-5, 2-9, 2-27, 3-11, 5-85-10, 7-21,
8-12, B-5. B-6, B-12, B-14, B-31B36, B-51, B-54
Liquidity
2-12-3, 2-10, 3-28, 4-24-8, 4-174-19, 5-5, 5-7, 5-12, 515, 6-1, 7-14, 7-21
Liquidity Ratio
4-14-3, 4-64-8, 4-17, 4-19, 5-1, 6-1
Long-term
Indebtedness Ratio
5-1, 5-115-13, 5-15
Long-term
Receivables
B-7, B-11, B-13
M
Margin Analysis
3-12
Marketable Security
1-6, B-9
Monetary Correction
1-1, 1-4, 1-29, 1-31, 1-32, 3-2, 8-2, 8-42, 8-43
Monetary Items
1-281-31
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INDEX
N
Net Worth
1-8, 1-13, 1-14, 1-33, 2-1, 2-6, 2-7, 2-9, 2-262-28, 3-11,
4-174-19, 5-15-13, 5-15, 5-16, 7-4, 7-5, 7-9, 7-10, 7-12, 713, 8-1, 8-3, 8-408-43, B-5, B-6, B-11, B-14, B-31, B-33, B36, B-52
Non-current Assets
1-8, 2-6, 3-10, 8-12, B-5, B-7, B-10, B-11, B-13
Non-current
Liabilities
1-8
O
Off-balance-sheet
Assets
B-34, B-36
Off-balance-sheet
Liabilities
B-34
Operating Credits
2-8, 2-11
Operating Ratio
7-21
Owners' Equity
8-12, B-6, B-12, B-36
P
Paid-in Capital
2-8, 2-11
Paid-in Surplus
B-33
Payables Turnover
Ratio
6-1, 6-2, 6-18, 6-23, 6-28
Permanent Capital
2-6, 2-11, 5-12
PPE
3-10, B-5, B-10
Prepaid Expenses
1-6, 4-6, 8-12, B-5, B-9, B-10, B-12, B-13
Profit on Sales
7-2
Profitability Ratio
4-3, 7-1, 7-2, 7-11, 7-13
Q
Quick Asset Ratio
4-1, 4-3, 4-44-8
v-2.0
v04/30/95
p05/24/00
INDEX
I-5
R
Realizing
B-7
Receivables
Turnover Ratio
6-16-3, 6-6, 6-7, 6-13
Reserves
B-5, B-33, B-36
Retained Earnings
1-6, 1-8, 1-30, 2-8, 2-11, 2-23, 3-11, 8-12, B-5, B-34, B-36,
B-52
Return on Assets
7-1, 7-3, 7-4, 7-117-13, 7-15
Return on Capital
7-4, 7-6
Return on Equity
5-4, 5-5, 7-1, 7-4, 7-5, 7-127-15
Return on Sales
7-1, 7-2, 7-117-15
Revaluation
1-12, 1-13, 5-7, 5-8, 8-41, 8-42, B-53
S
Shareholders' Equity
2-6, 2-11, B-6, B-33
T
Tangible Net Worth
1-13, 1-14, 5-65-8, 7-21
Third Party Capital
2-72-11, 2-25, 5-10
Total Indebtedness
Ratio
5-1, 5-2, 5-7, 5-11, 5-15, 7-21
Trade Receivables
3-10, 4-44-7, 6-16-4, 6-6, 6-7, 7-21, 8-11, B-5, B-9, B11, B-13
V
Vertical Analysis
3-1, 3-93-13, 3-25, 8-9
W
Working Capital
v04/30/95
p05/24/00
2-1, 2-32-7, 2-10, 2-11, 2-33, 4-5, 4-8, 5-12, 5-13, 5-15,
5-16, 6-16, 6-27, 6-28, 8-10, 8-46
v-2.0

Citibabank Financial Statement Analysis

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Financial Statement

Financial Statement Analysis

Unit 1: Accounting Issues in Financial Analysis

Unit 1: Accounting Issues in Financial Analysis (Continued)

Unit 2: Basic Concepts of Financial Analysis

Unit 2: Basic Concepts of Financial Analysis (Continued)

Unit 3: Financial Statement Analysis

Unit 4: Financial Ratios Liquidity

Unit 5: Financial Ratios Leverage

Unit 6: Financial Ratios Turnover

Unit 7: Financial Ratios Profitability

Unit 7: Financial Ratios Profitability (Continued)

Unit 8: Applied Financial Analysis Case Studies

Unit Six Financial Ratios Turnover

When you complete this workbook, you will be able to:

Identify accounting issues that impact the financial analysis process

Apply techniques that are used to evaluate a companys financial condition

Calculate financial ratios to understand the relationships among various

Apply the financial anlysis procedures using a bank spreadsheet model

which point out important elements in the

which is the "heart" of the workbook. These

which also appear in the Glossary. They

terms or phrases in the left margin which

which do exactly what they say check your

In addition to these unit elements, the workbook includes:

Unit One Accounting Exercise Answer Key

Financial Statement Structure

Definitions of all key terms used in

Guide for locating glossary items in

UNIT 1: ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

A business is a collection of economic and human resources devoted to a particular purpose

When you complete this unit, you will be able to:

Differentiate between managerial accounting, tax accounting, and

Recognize five issues to consider in the financial analysis process

Calculate monetary corrections of a company in a high inflationary

Explain the impact of inflation on determining a company's financial

Recognize some features of an electronic spreadsheet model for

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

In a broad sense, accounting can be separated into three major

Managerial accounting provides information to management, for

Tax accounting is governed by legislation in the applicable legal

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

Financial accounting provides information on the results of a

Since financial accounting results are used by people outside of the

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

The major difference between Latin American accounting principles

To interpret financial statements and make the necessary adjustments

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

An analyst must also understand the basics of balance sheet and

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

Due banks short term

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

Short-term bank debt.....................................................________

Check your answers with the Answer Key in Appendix A.

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

GETTING BEHIND THE NUMBERS

The objective of a good financial analyst should be to get behind the

Asset / liability valuation

Adjustments for inflation

Inflation and economic growth are examples of macroeconomic

ACCOUNTING ISSUES IN FINANCIAL ANALYSIS

Sector Accounting Norms

Different economic sectors have different norms for accounting