Professional Documents
Culture Documents
________
Harcourt, Inc.
13-1
Chapter Outline
LO 1
Effects of inflation:
n Statements are prepared using historical costs, which do not reflect the difference between
actual growth in unit sales and growth in sales dollars caused by increases in costs
LO 2
Horizontal Analysis
Horizontal analysis: analysis of financial results over a series of years (Exhibit 13-1, 13-2)
n Increases or decreases, compared to a base year, are in absolute dollars and as percentages of
the base year
n Publicly held companies must show, annually, the three most recent years in the income
statement and statement of cash flows, and two years for the balance sheet
LO 3
many annual reports include a multi-year analysis of selected items and ratios (Exhibit
13-3)
trend analysis: tracking items over a series of years
changes in the elements of the statement of cash flows are receiving increased attention
from analysts
Vertical Analysis
Common size statements recast all items on the statement as a percentage of a selected item on the
statement.
n On the balance sheet, all assets are a percent of total assets. Liability and equity accounts are
each a percent of total liabilities plus equity (Exhibit 13-5)
Harcourt, Inc.
LO 4
Liquidity is a measure of how close to cash the various assets and liabilities of a company are, that is,
the length of time before cash will be realized.
n Working capital is the dollar excess of current assets over current liabilities at a point in time.
it is of limited value, since it tells nothing about the composition of working capital, and
cannot be used in comparing companies of different sizes
Current ratio =
Current Assets
Current Liabilities
Standards exist for different industries despite the 2:1 rule of thumb analysts use
Composition of current assets and current liabilities is important in interpretation,
particularly the proportion of noncash assets
Acid test ratio, also known as quick ratio, is a stricter measure of the ability to pay current debts.
n Quick ratio of below 1:1 may indicate a need to liquidate marketable securities to pay
obligations, regardless of market prices of the securities at the time
n In assessing this ratio, information such as credit terms extended to the company by its
creditors, and by the company to its customers, along with due dates of other obligations, are
important
Harcourt, Inc.
13-3
n Inventory turnover measures number of times inventory is purchased, sold, and replaced
during a year
Inventory Turnover Ratio =
n Number of days' sales in inventory tells us how long it will take to sell the average item of
inventory
Number of Days sales in inventory =
days in period
inventory turnover
increase could signal obsolete inventory, problems with sales, or high prices causing
reduced demand
Cash to cash operating cycle is the time between purchase of merchandise and receipt of cash from
sale of that merchandise:
Cash to cash cycle = days' sales in inventory + days' sales in accounts receivable
LO 5
Solvency Analysis
Solvency is the ability to remain in business over the long term, and to remain financially healthy over
the period during which both long- and short-term debt will be outstanding.
Debt-to-equity ratio measures the relationship between liabilities and equity:
Debt to equity ratio =
n Sometimes measured as
Total Liabilities
Total Stockholders' Equity
total liabilities
total liabilities + total stockholders' equity
Times interest earned measures the ability to meet current-year interest payments:
Times interest earned =
Net Income
Interest Expense +
Interest Expense
Debt service coverage ratio measures the adequacy of cash generated by operations in covering debt
obligations:
Debt service coverage ratio =
n Sometimes the numerator used is earnings before interest, taxes, depreciation and
amortization
n The usefulness depends on changes in current assets and liabilities during a period
n Numerator and denominator figures can be found in the statement of cash flows or footnotes
13-4
Harcourt, Inc.
Cash flow from operations to capital expenditures ratio measures the ability of a company to finance
acquisitions of long-lived assets from operations:
Cash flow from operations to
cash flow from operations total dividends
=
capital expenditures ratio
cash paid for acquisitions
Profitability Analysis
LO 6
Profitability measures management's ability to use resources available to earn a return on funds
invested.
n Return is a relationship between income earned by the company and investments made by
various groups
n Return on assets is the broadest measure, calculating return on investments by all providers of
capital
Return on assets =
n Net income is measured after interest is deducted; common equity equals assets less liabilities
n Return on assets and return on equity are tied together in a phenomenon called leverage, the
practice of using borrowed funds and amounts received from preferred shareholders to earn a
higher overall return on common equity
n If the company can earn an overall rate that is higher than the rates they pay to preferred
shareholders and debtholders, it has been successful in its use of outside money, or can be
said to have employed favorable leverage
n If the company's net income should fall, and they pay more to these groups than they earn
overall, they will have unfavorable leverage and be at risk
Earnings per share (EPS) allows shareholders to calculate what their share of earnings is, and compare
it to what they paid for the stock:
Earnings per share =
Price-earnings (PE) ratio relates the price of a share of stock to earnings per share:
PE ratio =
Harcourt, Inc.
13-5
n Dividend payout ratio measures how much of the earnings actually go to the shareholders:
Dividend payout ratio =
n Dividend yield ratio measures the return on an investment measured by dividends paid:
Dividend yield ratio =
NOTE: Exhibit 13-8 in the textbook summarizes the most commonly used
financial ratios. Students may want to mark it for reference.
13-6
Harcourt, Inc.
Lecture Suggestions
The Wrigley comparative statistics in Exhibit 13-3 can generate a good discussion of what can be
found by comparing more than one statistic without doing any calculations.
LO 2
If students have been assigned exercises from the "Activities" section of this book involving
comparison of companies, they will have encountered situations where companies of very different
sizes had to be compared. Relating common size statements to students' ways of dealing with these
differences can launch a discussion on the use of common size statements.
LO 3
The cash to cash cycle and its components, the days in inventory and the days in accounts receivable,
can be explained in conjunction with the current ratio to assess the adequacy of the company's current
ratio. Similarly, days in accounts receivable measures how "quick" accounts receivable actually is.
LO 4
Students understand the concept of interest as the return on their investment in a bank account. From
there, they can make the transition to a stockholder's investment in a company, and the return the
company produces, in the form of net income. In a bank account, interest is not always withdrawn, but
is left to earn more interest than that which would be earned on the initial investment alone.
Stockholders do not withdraw as dividends all net income, but leave some invested in the company to
generate greater future income.
LO 6
The Review Problem at the end of the chapter, using the Wrigley statements, contains sufficient
information to use as an in-class example for most of the ratios, including solutions for many ratios.
Since students have the statements before them in their books, it is not necessary to reproduce them.
Detailed clarification and comment as you review the ratios add to what is given in the solution to the
Problem.
Harcourt, Inc.
13-7
Horizontal Analysis
In-class exercise: Wrigley income statement
The income statements for 1998, 1997, and 1996 for William Wrigley Jr. Company are presented in
the review problem in your textbook. Set up a worksheet with columns similar to the Henderson
Company example (Exhibit 13-1) in your textbook to do a horizontal analysis of Wrigleys income
statements. Round numbers to tenths of a percent to minimize rounding problems.
n Do you find any changes that you would consider significant and worthy of further
investigation? If so, what are they? Why are they important?
n Does the horizontal analysis make the comparative income statements more meaningful to
you as you try to evaluate Wrigleys performance?
n If you wished to evaluate the influence of inflation on the Wrigley income statements, what
factors would complicate your attempts to do so?
Solution
($ million)
1997 to 1998 change
1996
1998
1997
$ 2004.7
$ 1937.0
$ 1835.9
67.7
3.4
101.1
5.5
18.6
17.1
14.6
1.5
8.7
2.5
17.1
2023.3
1954.1
1850.5
69.2
3.5
103.6
5.5
848.3
847.3
814.5
1.0
.1
32.8
4.0
3.3
19.4
(13.7)
(16.1)
(82.9)
743.9
708.3
656.4
35.6
.6
.9
1.1
Revenues:
Net sales
Investment & other income
Total revenues
Costs and expenses
Cost of sales
Cost (gains) related to factory
Closure and sale
(10.4)
(415.1)
(.3)
5.0
(33.3)
51.9
(.2)
7.9
(18.1)
1582.4
1559.8
1491.4
22.6
(1.4)
68.4
400.8
394.2
359.1
6.6
1.6
35.1
4.5
9.7
Income taxes
136.3
122.6
128.8
13.7
11.1
(6.2)
(4.8)
Net earnings
$ 304.5
$ 271.6
$ 230.3
32.9
12.1
41.4
17.9
If you require or encourage the use of personal computers by your students, either at home or in an oncampus lab, students can set up the table on their own as an outside assignment, using a spreadsheet,
and come into class ready to discuss their findings. This will save class time.
n Growth in expenses outpaced revenue growth. In general, 1998 was a more difficult year than
1997 for the company. The growth rate slowed. Cost of interest and plant closure were
significant items.
n This is not a right answer question. Students are being asked to respond subjectively to the
effect of seeing the same information in a different format. Few would have noticed, for
example, the relatively smaller growth between 1997 and 1998 compared to 1996 and 1997.
13-8
Harcourt, Inc.
n Inflation can be measured in more than one way. One could look at the growth in costs versus
the growth in revenues. Alternatively, inflation could be measured by published standards
that record inflation in the economy. This is where problems arise. Since Wrigley does
business throughout the world, many inflation rates would be applied to the appropriate
figures to make this assessment, and the overall analysis would be difficult and perhaps
pointless.
Vertical Analysis
LO 3
n Did any items change significantly? If so, can you explain the change?
n Explain the foreign currency conversion: How did the foreign currencies fare against the U.S.
dollar, overall, in each of the two years? How did the two years compare?
n What does this format show that you did not see when you merely compared the two balance
sheets?
Harcourt, Inc.
13-9
Solution
($ and shares million)
1998
$
Assets
Current assets:
Cash and cash equivalents
Short-term investments, at amortized cost
Accounts receivable (less allowance for doubtful
accounts: 1998$7.5; 1997$7.5)
Inventories
Finished goods
Raw materials and supplies
Other current assets
Deferred income taxescurrent
Total current assets
Marketable securities at fair value
Deferred charges and other assets
Deferred income taxesnoncurrent
Property, plant, and equipment at cost:
Land
Buildings and building equipment
Machinery and equipment
Less accumulated depreciation
Total assets
Liabilities and shareholders' equity
Current liabilities
Accounts payable
Accrued expenses
Dividends payable
Income and other taxes payable
Deferred income taxescurrent
Total current liabilities
Deferred income taxesnoncurrent
Other noncurrent liabilities
Shareholders' equity:
Preferred stockno par value
Authorized: 20,000 shares
Issued: none
Common stockno par value
Common stock
Authorized: 400,000 shares
Issued: 199893.0 shares; 199792.5 shares
Class B common stockconvertible
Authorized: 80,000 shares
Issued and outstanding: 199823.2 shares;
199723.6 shares
Additional paid-in capital
Retained earnings
Foreign currency translation adjustment
Unrealized holding gains on marketable equity
securities
Common stock in treasury, at cost
(1998111 shares; 1997252 shares)
Total stockholders equity
Total liabilities and stockholders' equity
13-10
1997
%*
%*
214.5
137.7
14.10
9.05
206.6
120.7
15.38
8.98
194.9
12.81
175.91
13.09
64.9
191.1
25.3
15.0
843.1
39.8
92.1
25.5
4.26
12.56
1.66
.98
55.44
2.61
6.05
1.67
63.9
183.4
30.5
16.4
797.6
26.3
59.5
29.0
4.75
13.65
2.27
1.22
59.38
1.95
4.43
2.15
36.0
310.2
642.5
988.7
468.6
520.0
$ 1520.8
2.36
20.39
42.24
65.01
30.81
34.19
100.00
26.2
277.8
566.7
870.8
440.3
430.4
1343.1
1.95
20.68
42.19
64.83
32.78
32.04
100.00
76.6
67.8
23.2
49.4
1.3
218.6
40.3
104.8
5.03
4.45
1.52
3.24
.08
14.37
2.64
6.89
71.0
78.3
22.0
53.4
.9
225.8
30.8
101.0
5.28
5.82
1.63
3.97
.06
16.81
2.29
7.51
12.4
.81
12.3
.91
3.0
.2
1184.6
(61.3)
24.6
(6.7)
1157.0
$ 1520.8
.19
.01
77.89
(4.03)
1.61
(.44)
76.07
100.00
3.1
.2
1032.1
(65.0)
15.9
(13.3)
985.3
$ 1343.1
.23
.01
76.84
(4.83)
1.18
(.99)
73.36
100.00
Harcourt, Inc.
* Each asset is expressed as a percentage of total assets; each liability or equity account is expressed as
a percentage of total liabilities plus equity.
n Balance sheet amounts are remarkable for their relative consistency. Changes in the
percentages between the two years were all immaterial.
n Foreign currencies in which Wrigley had holdings declined relative to the dollar in aggregate
in both years. The relative decline was slightly less in 1998.
n The absolute dollar statements let the reader see increases (or decreases) in individual items;
the common size statements show the relative proportions of the balance sheet items (for
example, current assets to total assets, or liabilities to total liabilities plus equity), which may
be useful in seeing whether the perceived growth is uniform, or concentrated in certain areas,
or shifting between balance sheet accounts.
LO 4
n Calculate Dell's quick ratio. Is the difference significant between the current and quick
ratios? Can you explain what the difference means?
n Use the calculation of days in accounts receivable to evaluate Dell's current ratio. Based upon
the business Dell is in, how would you expect their accounts receivable to differ from the
receivables of other companies?
n Calculate days in inventory for Dell. How does the type of business Dell is in influence the
contents of Dell's inventories, and how long these inventories are on hand?
n Calculate Dell's cash to cash cycle. What factors affect the companys ability to generate
cash?
n Is the cash flow from operations to current liabilities ratio a better indicator of Dell's ability to
generate enough cash to satisfy short-term obligations? Why or why not?
Solution
current assets
3912
=
current liabilities
2697
= 1.45 : 1
n The quick ratio is somewhat smaller. Students will probably use for quick assets, cash, shortterm investments, and accounts receivable, which compared to current liabilities yield
320 + 1,524 + 1,486
2697
= 1.23 : 1
Dells inventories are not so significant to distort the current ratio. Thus the current ratio, subject to
accounts receivable and inventory turnover, is a fair indicator of liquidity.
Harcourt, Inc.
13-11
12,327
(1, 486 + 903) / 2
= 10.31 times
n Related companies:
Apple Computer
5.5
Digital Equipment Corp. 4.1
Hewlett Packard
4.7
Days in accounts receivable =
360
= 34.9 days
10.31
The company collects its accounts receivable, on the average, in 35 days. This does not appear a
particularly long collection period, especially when turnover for related companies is noted.
n Inventory turnover =
Days in inventory =
360
39.69
9,605
(233 + 251) / 2
= 39.6 times.
= 9.07 days
n Cash to cash cycle = 35 + 9 = 44 days. Key factors are the extra steps involved in
manufacturing, balanced by Dells efforts at quick turnaround of inventories.
1,592
2,697
= .59 : 1.
Notwithstanding the fact that its focus is on cash, which is needed to satisfy liabilities, it is only one
indicator. None are better, but must be considered in the context of related ratios, and also in
comparison to similar companies.
n Some comparisons:
Apple Computer
(.10)
Digital Equipment Corp. (.08)
Hewlett Packard
.15
13-12
Harcourt, Inc.
Solvency Analysis
LO 5
n Calculate Dell's debt to total capitalization (a form of debt to equity) ratio (use total liabilities
+ stockholders' equity as the denominator) for 1998 and 1997. How has it changed? Does
Dell appear to depend heavily on debt financing? How do they compare to similar
companies?
n Study Dells Statement of Cash Flows. How is Dell likely to finance fixed assets in the
foreseeable future?
Solution
1,908
2,993
2,975
4,268
= 69.7 %
= 63.7%
Compared to other companies, with debt at 75% to 90% of total financing not uncommon, Dell does
not look overly leveraged. The ratio changed little from 1997 to 1998. It is useful to remind students
that it is good management for a business to use debt for a portion of its financing if it can earn a
higher rate of return on the funds obtained than the borrowing rate for the debt.
Apple Computer
28.2 %
Digital Equipment Corp. 22.5 %
Hewlett Packard
51.5 %
n Since Dell has more than adequate cash flow from operations to pay back its current debt in
full even after capital expenditures, it is in a good position to decide to either expand using
operating cash, or to borrow additional money at advantageous rates (see exercise on
leverage) with no immediate risk of not meeting principal or interest payments.
Profitability Analysis
LO 6
n Why does the new building put this manager at a disadvantage relative to her compensation?
n Can depreciation be calculated differently for reporting and managerial evaluation? Why or
why not?
n What problem would this decision present for the company as a whole?
n Do you think that a company has any flexibility in how it calculates return on assets (or any
ratio, for that matter) for internal use?
2
Op. Cit.
Harcourt, Inc.
13-13
n What would you, as the company officer who supervises both managers, suggest as a solution
to this problem?
Solution
n The manager is at a disadvantage because the net book value of her assets, which will include
the new building and fixtures, will be much higher than that of the older building. Thus, for
comparable net income, she will show a lower return on assets.
n The increase in performance would not be a genuine improvement, merely a form of book
cooking. It would be surprising if she had the freedom to unilaterally make this decision.
However, the companys formula for calculating executive compensation is not subject to the
rules of reporting, but is an internally governed matter.
n For the company as a whole, unless they can show some justification to the contrary, like
assets should be treated in the same way. Thus, they would not use two different depreciation
methods for two managers.. Although different assets can be depreciated differently, it would
be difficult to make a distinction between two buildings.
n For internal purposesthat is for numbers that will not be publishedthe company does have
flexibility. They can change the definition of total assets to, for example, cost rather than
net book value, or even to current market value. Even in published figures, some variation is
found, leading the wise reader to conclude that it is best, if you want to be sure you are
comparing the same numbers for two companies, to calculate the ratios yourself.
n Book cooking notwithstanding, the manager of the newer building does have a legitimate
complaint. The two managers are not being evaluated equally. The supervisor could set
different standards for each hotel, or change the elements of the calculation to compensate for
differences between facilities. Evaluation systems frequently raise controversy, and
companies resort to detailed, complex bonus formulae to eliminate bias. The use of target
figures for return can serve as a disincentive to capital investments if new assets appear to
penalize managers.
Note to instructor:
For the sake of consistency, and to show how the ratios taken together present a
more complete picture, Dell was used for most ratio calculations in this Chapter.
However, many of the ratios were introduced earlier in the text, and exercises for
them appear in this manual using other companies.
13-14
Harcourt, Inc.
320
1,524
1,486
233
349
3,912
342
14
$4,268
115
1,237
903
251
241
2,747
235
11
$2,993
$ 1,643
1,054
2,697
17
225
36
---2,975
----
$ 1,040
618
1,658
18
219
13
---1,908
279
----
----
747
607
(61)
1,293
$4,268
195
647
(36)
806
$2,993
Op. Cit.
Harcourt, Inc.
13-15
13-16
($ 000)
Fiscal Year
1997
$ 12,327
9,605
2,722
7,759
6,093
1,666
1,202
204
1,406
1,316
52
1,368
424
944
---944
---$
$
$
1.44
---1.44
1.28
----1.28
658
738
$ 5,296
4,229
1,067
826
126
952
714
33
747
216
531
(13)
518
----
944
January 28
1996
518
$
$
$
$
595
95
690
377
6
383
111
272
---272
(12)
0.75
(.02)
0.73
0.68
(.02)
0.66
710
782
260
$
$
0.36
---$ 0.36
0.33
----0.33
716
790
Harcourt, Inc.
($ 000)
Fiscal Year
1997
518
$ 272
67
24
47
29
38
22
529
28
1,592
659
109
1,362
(12,305)
12,017
(187)
(475)
(9,538)
8,891
(114)
(761)
(4,545)
4,442
(101)
(204)
(1,023)
Issuance of common stock under employee plans
88
Cash received from sale of equity options
38
Preferred stock dividends paid other
(1)
Net cash provided by financing activities
(898)
Effect of exchange rate changes on cash
(14)
Net increase in cash
205
Cash at beginning of period
115
Cash at end of period
$ 320
(495)
(95)
57
(533)
(8)
60
55
115
48
(14)
34
7
12
43
55
Harcourt, Inc.
$ 944
January 28
1996
(195)
39
176
13-17