2-1 2-2 The four financial statements contained in most annual reports are the balance sheet, income statement, statement of retained earnings, and statement of cash flows. No, because the $20 million of retained earnings probably would not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the assets of the firm. Liquidating assets, borrowing more funds, and issuing stock would constitute sources of funds. Purchasing assets, paying off debt, and stock repurchases would constitute uses of funds. Thus, the following general rules can be used to determine what changes in balance sheet accounts represent sources and uses if funds: Sources of cash: ↑ in a liability or equity account ↓ in an asset account 2-4 Uses of Cash: ↓ in a liability of equity account ↑ in an asset account


The emphasis of the various types of analysts is by no means uniform, nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Long-term creditors are more interested in the debt ratio, TIE, and fixed charge coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the liquidity ratios. The most important aspect of ratio analysis is the judgment used when interpreting the results to reach an overall conclusion concerning a firm’s financial position. The analyst should be aware of, and include in the interpretation, the fact that: (1) large firms with many different divisions are difficult to categorize in a single industry; (2) financial statements are reported at historical costs; (3) seasonal factors can distort the ratios; (4) some firms try to “window dress” their financial statements to look good; (5) firms use different accounting procedures to compute inventory values, depreciation, and so on; (6) there might not exist a single value that can be used for comparing firms’ ratios (e.g., a current ratio of 2.0 might not be good); and (7) conclusions concerning the overall financial position of a firm should a representative number of ratios, not a single ratio. Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain such as Safeway. Also, profit margins and turnover ratios might vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain like Safeway to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin (e.g., grocery chain), and vice versa.



Chapter 2


ROE can be written
ROE = NI NI TA = × Owners ' equity TA Owners ' equity

Total assets divided by owners’ equity, which is termed the equity multiplier, is a measure of debt utilization (the inverse of the percent equity the firm uses); the more debt, the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE. However, as more debt is used, the chance of financial distress increases. If the risk of bankruptcy is high then the cost of debt could increase to the point where additional debt is detrimental to the firm. 2-8 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary unless averages (monthly ones are best) are used. Common equity is determined at a point in time, say, December 31, 2008. Profits are earned over time, say, during 2008. If a firm is growing rapidly, year-end equity will be much larger than beginning-of-year equity, so the calculated rate of return on equity will be different depending on whether end-of-year, beginning-of-year, or average common equity is used as the denominator. Average common equity is conceptually the best figure to use. In public utility rate cases, people are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on equity appear excessive or inadequate. Similar problems can arise when a firm is being evaluated.



Net income represents the revenues net of expenses and taxes that the firm generates during a particular accounting period. Because firms use “accrual accounting” to account for revenues and expenses, revenues are recognized when they are earned, which could differ from when the cash is received, and expenses are recognized when they are incurred, which could differ from when the cash is paid. On the other hand, net cash flow represents the amount of cash net of cash expenses and taxes that the firm receives during the accounting period. Generally, the net income differs from the net cash flow because the firm recognizes a large non-cash expense called depreciation. Net cash flow is the “bottom-line” amount of cash that the firm generates during an accounting period, which represents the total cash inflows minus the total cash outflows. Operating cash flow is the net cash flow that is generated from normal operations—for example, manufacturing and selling inventory—before considering the effects of financing on the “bottom-line” cash flow. Free cash flow measures the cash flow that the firm is free to pay to investors (both bondholders and stockholders) after considering the cash investments that are needed to continue operations, including investments in fixed assets needed to manufacture products, working capital needed to continue operations, and new opportunities that will grow the stock price. We compute the free cash flow by subtracting the amount that is needed to fund investments during the year from operating cash flow: Free Cash Flow (FCF) = Operating cash flow – Investments. 2009 $ 400 250 450 1,100 1,000 $2,100



2-12 Cash Accounts receivable Inventory Current assets Net property & equipment Total assets 2008 $ 500 300 400 1,200 950 $2,150

Source(+) or Use(-)? + + – –*

m. h. Short-term promissory notes are issued to trade creditors in exchange for past due accounts payable. A fixed asset is sold for less than its book value. Equipment is purchased with short-term notes.500 = 2. A fixed asset is sold for more than its book value. j. l. The retained earning balance increased in 2009. Because the book value of fixed assets increased. p. Batelan must have purchased addition fixed assets. But. q.150 – + + – 1. g. o.312.750 – + The book value of property and equipment is stated net of depreciation.Chapter 2 Accounts payable Accruals Notes payable Current liabilities Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities and equity * $ 200 300 400 900 800 250 150 400 $2. Current operating expenses are paid. f.5 × currentratio $525. Cash is obtained through short-term bank loans. so Batelan must have generated a positive net income. without more information we cannot determine the amount of the purchase. the amount of net income). Inventory (raw materials) is purchased on credit.e. + + ─ + + + ─ ─ + ─ 0 ─ 0 0 0 0 + Current Ratio + + + + + + + ─ ─ ─ 0 ─ 0 + 0 ─ ─ Effect on Net Income 0 + 0 ─ + + 0 0 0 ─ 0 ─ 0 0 0 0 0 _____________________________________________________________ PROBLEMS 2-1 Pr esent = $1. b. Accounts receivable are collected. and depreciation is an adjustment that reduces the account balance. Federal income tax due for the previous year is paid. Merchandise is sold on credit.100 $ 400 250 200 850 900 1. c. we cannot tell whether dividends were paid in 2009. n. 2-13 a. i. Long-term bonds are issued to pay off accounts payable. Advances are made to employees. e.700 300 100 400 $2. k.000 3 . Payment is made to trade creditors for previous purchases. But. d. Total Current Assets Cash is acquired through issuance of additional common stock. Merchandise is sold for cash. Marketable securities are sold below cost. A cash dividend is declared and paid. without additional information (i.

000 = $120.511.0 × C u rre nlia b ilitie t s C u rre n ts s e tsIn v e n to rie a s = 1.000 Current liabilities = $270.000.0 × currentratio $525.000 + 2ΔNP ΔNP = $262.Chapter 2 M inim um = $1.628 0. = 3 .500/$787. Quick ratio= ($1.000 ─ $637.86 (Sales) CGS = $2.500 + ΔNP = $1.000 = $2.000− Inventorie s = 1.000 Accounts receivable = $258.050.500+ ∆ N P = 2. Because we assumed that the additional funds would be used to increase inventory.0 × C u rre nlia b ilitie t s $8 1 00 0 0 . 4 × C u rre n t b ilitie lia s $810.312.000 (2) (3) Current assets = Cash + Marketable securities + Accounts receivable + Inventories $810. 0 × Inventory CGS = 5.575.312.500.86 4 . 0 × $432.000 (5) CGS = 0.000 (4) C ostof goodssold = 5.500 = $937.500 without violating a 2-to-1 current ratio.575.000+ ∆ N P $1. 4 × $270.500 = 1.000 Inventories = $432. Short-term debt can increase by a maximum of $262.160. assuming that the entire increase in notes payable is used to increase current assets.000 + Accounts receivable + $432. the inventory account will increase to $637.000 Sales = $2. and current assets will total $1.500.19x 2-2 (1) C u rre na s se ts t = 3 .160 .500)/$787.

000 – 0)(1 – 0.000 x 0. so find EBIT and INT Interest = $500.000 = 9.0 = Sales/TA.000 + ($ 1500 .511. c.000 = (Sales .000 + $300. 0.000. NI = (Sales – Operating costs – Interest expense)(1-T) $650. so Equity/TA = 40%. Debt = TX x Debt/TA = $5.000 5 .8% 2-5 2-6 Net cash flow = $180.000 = = 37 days $2.000 EBIT = $125.000 = 24.000/2 = $5.000.000 x 0.000 ( 300) $ 700 ( 210) $ 490 Now we can use some ratios to get some more data: Total assets turnover = 2.000 ROE = NI/E = $490/$2.000 Taxable income (EBT) = $100.1 = $50.000 + $50.000 x 0. Equity = TA x Equity/TA = $5.Chapter 2 Accounts receivable (6) DSO = Sales / 360 $258.000 Operating cash flow = $950.5 x 2-4 ROE = NI/Equity Now we need to determine the inputs for the equation from the data that were given.000 . therefore. and we put numbers in it on the right: Sales (given) .000 TIE = $175. TA = Sales/2 = $10.000 ) = $2.T) = $100.Taxes (30%) NI $10. On the left we set up an income statement.40 = $2.000 + $50.000/$50. Net cash flow = $650.5%.000 = $950.500.05 = $100.65 b.000 x 0.800 .000 = $175.000 Debt/TA = 60%.000 $3.000 = 3.000/(1 .INT (given) EBT .6 = $3.000 na $ 1.000 a.000 Alternatively.000/0.000 + $300 .$1.Cost EBIT (given) .35) Sales = $650 . and ROA = NI/TA = $490/$5.628 / 360 2-3 TIE = EBIT/INT.$300.000 .8 = $125.000 Net income = $2.000 = $230. Equity = TA – Debt = $5.000 = $2.

91% increase.000. if we use the reciprocal of ROE we have the following equation: Equity Equity NI 1 = × = 3. ROE will increase by 13. b.250 = 5.000/10.000 ─ 4.60 = 60% A ssets A ssets NI 0.000 = 7. Assuming that net income is unchanged.50 = $1.5x.000 = $115.250. the new ROE will be ROE 2 = $15.000 + $20. (3) If the company had 10. current assets amount to $210.50. (1) Doubling the dollar amounts would not affect the answer.000/$40 = 2. This is the level of current assets that will produce a current ratio of 2.6087 ─ $1. given the facts of the problem. which would mean a new ROE of $15.000 = 10.71% ─ 7. or 2 x $20 = $40. so the increase in EPS would be $2.125).4) – 0.5 = 2%. which is NI/Equity.05 Debt/Assets = 1 .000.000/$140.54%.0% Thus. ROE is ROE1 = $15.Chapter 2 2-7 2-8 EVA = $150.04%.000 = $1.000 = $85.000/$115.5(CL) = 2.5) 3%/1. (5) If the stock was selling for twice book value. We can also calculate Zumwalt’s debt ratio in a similar manner.10($1.000 shares outstanding. Zumwalt's profit margin = 2% and its debt ratio = 40%.000/10.100. the ROE increase would still be 5. so we can solve to find the new level of current assets: CA = 2.000 = 13.000 ─ $85.000/$200. leaving 10.Equity/Assets = 1 .000(1 – 0.000 = $30. If the $85.000 We are given ROA = 3% and Sales/Total assets = 1.000) = -$20.1087.50% = 3. which is NI/A and ROE. At present.40 = 40.000) = $125.000/$20 = = $20. The stock has a book value of $200. The new EPS would be $15.71%. then its EPS would be $15.000 ─ $125.5% The current ratio will be set such that 2.000/5.04% ─ 7.750 shares.000.6087.000 generated is used to retire common equity.21%.0% × = 0. We are given ROA.5($50.5x From DuPont equation: ROA 3% Profit margin = = = Profit margin x Total assets turnover Profit margin (1. so the remaining shares would 6 . Currently. Therefore. so they can be reduced by $210. which is a 73.000. 2-9 a.60 = 0.750 = $2.54%. (2) Current assets would increase by $25. CL is $50. which would mean a difference of 10. and it will not change.5 = CA/CL.000. then the new common equity balance will be $200. so the shares retired would be $85. then only half as many shares could be retired ($85. the same as the increase in ROE.50% = 5.

000/7. for an increase of $1.875 = $1. then move to a lower DSO which would require a reduction in receivables. we could have had you use the funds generated to retire debt.4048. will the effect on EPS and/or ROE be affected by whether the stock sells above. at. we could have focused on fixed assets and the FA turnover ratio.875. In any of these cases. For example. either as a part of the problem or without any reference to the problem.9048 ─ $1. then we would have had to finance this increase by adding either debt or equity. which would have lowered interest charges and consequently increased net income and EPS. but it affects cash in the form of taxes on the income statement 7 .Chapter 2 be 10. then had you calculate the DSO. which would have lowered ROE and EPS.000 ─ 2. 31 $ 15 11 22 75 $123 $125 35 $ 90 $213 $ 15 15 7 24 57 95 $213 Source $ 8 22 50 10* Use $ 8 11 3 12 8 16 28 28 $102 $102 *Depreciation is not a source of cash. 1 $ 7 0 30 53 $ 90 $ 75 25 $ 50 $140 $ 18 3 15 8 29 67 $140 Dec. We could have started with lower inventories and higher accounts receivable. 2009 ($ millions) Cash Marketable securities Net receivables Inventories Total current assets Gross fixed assets Less: depreciation Net fixed assets Total assets Accounts payable Notes payable Other current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity Jan. or below book value?” 2-10 a. c.9048. other things held constant. If we had to increase assets. Similarly.125 = 7. “If funds are generated by reducing assets. and then determine the effects on ROE and EPS under different conditions. and if those funds are used to retire common stock. Sources and Uses of Funds Analysis: Lloyd Lumber Company Balance Sheet. note that we could have asked some conceptual questions about the problem. Finally.5000 = $0. and the new EPS would be $15.

75 x $12.4 $12.5) $ 1.0) -( 9. except depreciation ( 9. selling common stock.Chapter 2 b. and retaining earnings. 2009 ($ millions) Operating Activities: Net income Other additions (sources of cash): Depreciation Decrease in accounts receivable Subtractions (uses of cash): Increase in inventories Decrease in accounts payable Decrease in other current liabilities Net cash flow from operations Long-term Investing Activities: Acquisition of fixed assets Financing Activities: Increase in notes payable Sale of long-term debt Sale of common stock Payment of dividends Net cash flow from financing Net increase in cash and marketable securities Cash and marketable securities at beginning of year Cash and marketable securities at end of year $ 12 16 28 ( 5) $ 51 $ 19 7 $ 26 $ 33 $ 10 8 ($22) ( 3) ( 8) $ 18 ($ 50) c.6) (Cash taxes) $ 2.0 (Pre-tax CF) ( 0. Ratio analysis and the sources and uses statement both indicate a healthy situation.6) $ 0. and the debt ratio has gone down slightly. A quick check of the ratios shows that the company's credit has not deteriorated—the current and quick ratios have increased.0)* Depreciation ( 1.0 (10. Lloyd Lumber Company Statement of Cash Flows.9 1. Cash Flows $12. The remainder was obtained from increasing notes payable and reducing receivables. Income Statement Sales revenues Costs.0 = $9.0 ( 9. except depreciation = 0. Funds were also utilized to reduce accounts payable and other current liabilities and to increase the cash and marketable securities accounts.5 $ 2.0 8 . Dollars are in millions.4 Costs. Most funds were obtained by increasing long-term debt. Investments were made in plant and inventories.5 ( 0.5) Total operating costs Net operating income (NOI) Taxes (40%) Operating income after taxes Add back depreciation Cash flow from operations * 2-11 a.0) (Cash costs) $ 3.

00) (Cash costs) $ 3.$1. except depreciation Depreciation Total operating costs Net operating income (NOI) Taxes (40%) Operating income after taxes Add back depreciation Cash flow from operations $12. Inventory = = turnover Inventorie s $200 40.0)(0.$1.6) = $0.0 (9.90) (Cash taxes) $ 2.81x $160 Days sales Accountsreceivable = = outs tan ding Sales / 360  $1.0) (Cash costs) $ 3.0)(0.25 .0)(0.10 Cash Flows $12.14 days 33.6) = –$0.88x 4.2x 4.0) $ 0.0) --( 9.75) ( 9. Dollar amounts are in millions.0 ( 0.10x 7.Chapter 2 Net income = (NOI – Interest)(1 – T) = ($1.5 days Poor 5. Income Statement Sales revenues Costs.0) (Cash taxes) $ 3.5 .0 $ 3.10 (9.$1.0 (9. Depreciation halves.0) (12.0 (Pre-tax CF) ( 0. Fixed assets = = turnover Fixed assets $350 9 .75) $ 2.0 Net income = (NOI – Interest)(1 – T) = ($0.75 d. Depreciation doubles.435   360    Cost of goods sold $1176 . Income Statement Sales revenues Costs.00) (0.0) $ 0.00 (9.6) = $0. Industry Average 3.0) (3.6 c. Unilate Current = Current assets = $400 ratio Current liabilitie s $105 2-12 a. The after-tax cash flows are greater if Congress increases the allowance for depreciation.0 .35 0.90) $ 1.7 .00 (Pre-tax CF) ( 0.3 b.00) --( 9.0 Cash Flows $12. except depreciation Depreciation Total operating costs Net operating income (NOI) Taxes (40%) Operating income after taxes Add back depreciation Cash flow from operations $12. so you should prefer greater depreciation.25 ( 0.0 3.00 Net income = (NOI – Interest)(1 – T) = ($2.75 $ 2.1x Poor Average Sales $1 435 .9x Comment Near average 3.

0 days Cost of goods sold $1353 .6x 1.300 $1 607 .11x 4. introducing new products.70x 3.0% 4.1% 7.2 days 4.1 days 5. The ratios do not show any particular strengths.8 x 40. It would be helpful to know the future plans Unilate has with respect to improving its current financial position.6% 6.0x 2-13 a. This comparison shows that Unilate’s financial position worsened from 2008 to 2009.9 x 50. Industry Average 2.9% Trend Worse Worse Worse Worse Worse Worse Worse c.6x Marginal Return = Net income = $59 on assets Totalassets $750 7. According to its 2008 ratios.9% 3. Ratio Current ratio Days sales outstanding Inventory turnover Fixed assets turnover Debt ratio Profit margin on sales Return on assets 2009 3.500 . liquidating unprofitable investments.500 Sales $1 607 .000 $4.2 days 35.6 x 43.000 . Perhaps the fixed assets turnover ratio and return on assets figures are low because the firm has expanded its product distribution. 5.Chapter 2 Debt = Total debt = $360 ratio Total assets $750 $59 Net profit Net income = = m arg in Sales $1 435 .9% 10 3.4% 2008 3. it appears Unilate has liquidity problems.0% 43.7% 1. and so on.000 Accounts receivable Sales / 360 = $336 . d. 48.2% Net income $27.300 = Total assets $947 . = Inventorie s $241.60x 5.9% Poor b.500 Net income Sales = $27 . higher than normal days sales outstanding. Campsey Current assets $655.465 . and poor return on assets.6 x 3.1 x 48.0% Poor 4.87% 9.000 = Current liabilitie s $330. Unilate does have a low inventory turnover.28 1. = Total assets $947 .98x 75.6% .500 . and this process has a large cost “up front” with significant payoffs beginning in two or three years.500 2. However.9 x 4.0x 1.

9%.2% x 3.7 = 2. The total assets turnover ratio is well below the industry average so sales should be increased.0% Total debt $586 .000 = $90.6%.000 + $45.000.500 = Total assets $947 .000(. Industry .Chapter 2 Net incom e Com on equity m = $27 . indicating that the firm should tighten credit or enforce a more stringent collection policy.9% 60.000 .7% x 1.500/5 = $67. c. If 2009 represents a period of supernormal growth for Campsey. Fixed assets = Total assets ─ (Cash + Accts Rec. Accounts receivable = (Sales/360)(DSO) = ($450. Potential investors who look only at 2009 ratios will be misled. + Inventories) = $300. (Cash + Accounts receivable)/(Accounts payable) = 0.000. Debt = (0. Accounts payable = Debt ─ Long-term debt = $150. assets decreased.5 x Total assets = 1.0. While Campsey’s profit margin is higher than the industry average. Campsey’s days sales outstanding is more than twice as long as the industry average.500 = $52. or both.000.5 x $300.000 Cost of goods sold = Sales(1 .500 61.80)(Accts payable) Cash + $45. its other profitability ratios are low compared to the industry—net income should be higher given the amount of equity and assets. For Campsey.000. and a return to normal conditions in 2010 could hurt the firm’s stock price.25) = $450.000 ─ $60.$150.500 Inventory = (CGS)/5 = $337.000) = $150.000/360)(36) = $45.500) = $160.300 $361 .000 + $67.50)(Total assets) = (0.000 7. For the industry.500. Total liabilities and equity = Total assets = $300.6% 9.80x Cash + Accounts receivable = (0.500 Sales = 1.000. ROA = 1. However. ROA = PM x TA turnover = 1.000 = (0. 2-14 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) 2-15 a.80)($90.000 .0% b.50)($300.500.75) = $337.000 ─ $45.0 = 3. the company seems to be in an average liquidity position and financial leverage is similar to others in the industry. ratios based on this year will be distorted and a comparison between them and industry averages will have little meaning.000 ─ ($27.000 = $27.000) Cash = $72. Common stock = Total liabilities and equity – Debt – Retained earnings = $300.000 = $450. Finnerty 11 d.$97.

0% 8.4% 1.5x 29.00% 30.0x In v e n to ry C o s to f g o o d s o ld $6 6 0 = = In v e n to rie s $1 5 9 tu rn o v e r DSO = Accounts receivable $66 = Sales / 360 ($ 795 / 360 ) 4.77 = 6.Chapter 2 Furniture Current assets $303 = Current liabilitie s $111 Average 2.0 x 1.15x 8.00% 9.41x 6.5 earned Interest $4.0% 11.4% × 1.0% 3. ROA = Profit margin x Total assets turnover = Net income Sales × Sales Total assets $27 $795 × $795 $450 = = 3.57% 12.00x 7.5 30.0 x 3.40% 3.0% Comment Good Poor Poor 12 .77x 3.0x 2.8x 6.9% b.0% Profit margin Total assets turnover Return on total assets Finnerty 3.0% 6.73x Debt $135 Debt = = ratio Total assets $450 Times interest = EBIT = $49 .89 days 24.0 x 9.0 days Sales $795 Fixed assets = = turnover Fixed assets $147 Sales $795 Total assets = = turnover Total assets $450 Net income $27 Net profit = = margin Sales $795 Return on = Net income = $27 total assets Total assets $450 Re turn on = Net income = $27 equity Total equity $315 5.0% Industry 3.

8% 2. Thus. all of which are too low.57 5. or the current level of assets should be decreased to be more in line with current sales. and ROA. but it is difficult to say precisely how that ratio would be affected. 6.a. or if it grew rapidly during the year. as well as those based on sales. It is possible to correct for such problems by using average rather than end-of-period figures. It would have some impact on the current ratio. Cary appears to be poorly managed—all of its ratios are worse than the industry averages. and strengthening the debt position. A decrease in the inventory level would improve the inventory turnover. Either sales should be increased at the present level of assets.6x 9.8 days 10. could be biased.65 Industry 1.5% $4. a low P/E.0x 37. as shown by a slightly lower than average fixed assets turnover ratio.71 $23. If Finnerty’s inventory could be reduced this would generate funds that could be used to retire debt. if dividends were not increased. The lower cost of goods sold would improve all of the profitability ratios and. All of this should lead to a higher market/book ratio and a higher stock price.0x 0.0x 2. thus reducing interest charges and improving profits.2% 50. and common equity. and a low M/B ratio.0x 2. 2-16 a. receivables.0 days 13.1% 54. then the current ratio would improve. total assets turnover. There might also be some excess investment in fixed assets. perhaps indicative of excess capacity. would lower the debt ratio through increased retained earnings.a. 13 . inventories. Analysis of the DuPont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low.1% 18. this is not nearly as clear-cut as the over-investment in inventory.a.0x n. e. the problem appears to be in the balance sheet accounts. n.5% n.Chapter 2 c.3x 5.7x 5.0x 2.8x 32. Here are Cary's base case ratios and other data as compared to the industry: Quick Current Inventory turnover Days sales outstanding Fixed assets turnover Total assets turnover Return on assets Return on equity Debt ratio Profit margin on sales EPS Stock Price P/E ratio M/B ratio Cary 0. Ratios involving cash. a low stock price.33x 4. and current liabilities.0% 3. and the result is low earnings. Comment Weak Weak Poor Poor Poor Poor Bad Bad High Bad --Poor -- d. The comparison of inventory turnover ratios shows that other firms in the industry seem to be getting along with about half as much inventory per unit of sales as Finnerty. If the lower inventory level allowed Cary to reduce its current liabilities. many ratios might be distorted.9% 13. b. The company needs to do something to improve. However.85x 2. profits. If Finnerty had a sharp seasonal sales pattern.

700 ( 76.000 491.000 ( 2.000 ( 146. SHE GATHERED THE FOLLOWING FINANCIAL STATEMENTS AND OTHER DATA.500) $ 146.000 836.900) ($3.300) ( 20.800 2009 $3.880 BALANCE SHEETS ASSETS CASH ACCOUNTS RECEIVABLE INVENTORIES TOTAL CURRENT ASSETS GROSS FIXED ASSETS LESS: ACCUMULATED DEPRECIATION NET FIXED ASSETS TOTAL ASSETS LIABILITIES AND EQUITY ACCOUNTS PAYABLE NOTES PAYABLE ACCRUALS TOTAL CURRENT LIABILITIES LONG-TERM DEBT COMMON STOCK RETAINED EARNINGS TOTAL EQUITY TOTAL LIABILITIES AND EQUITY INCOME STATEMENTS SALES COST OF GOODS SOLD OTHER EXPENSES DEPRECIATION TOTAL OPERATING COSTS EBIT INTEREST EXPENSE EBT TAXES (40%) NET INCOME EPS 14 .600 200.220 $0.850.468.432 460.988 $ 685.960 $0.200 225.800 $ 175.442 $ $ 2008 57.000) ( 430.200) $ 360. 2009 52.000) ($3.600 351. TO BEGIN.900) $ 209.800 2008 $3.200 424.000 140.290.612 460.600 323.000 $ 540.600 ( 58.640) $ 87. A MANUFACTURER OF ELECTRONIC COMPONENTS.000) $ 73.000 ( 166.300) $ 149.000 ( 3.222.000 $ 481.000) ( 340.200 715.000 136.468.000 203.250.432.800 $ 145.000 225.700.200 $1. HER FIRST TASK WAS TO CONDUCT A FINANCIAL ANALYSIS OF THE FIRM COVERING THE PAST TWO YEARS.768 $ 663.988 $1.200) $ 344.000 527.124.650.Chapter 2 INTEGRATIVE PROBLEM 2-17 DONNA JAMISON WAS RECENTLY HIRED AS A FINANCIAL ANALYST BY COMPUTRON INDUSTRIES.000) ( 18.000 402.800 $1.650.768 $1.000 $1.700 ( 29.800 $1.864.480) $ 44.100 ( 62.


Computron’s cash account still fell by $5. depreciation. Explain that some data (net income. C.290000 . so its operations are draining cash despite the positive net income reported on the income statement.200 in obligations that must be satisfied within the coming year. and to pay dividends. The cash flow statement highlights some important aspects of Computron’s financial condition.39 × C urrent liabilitie $540200 s . 16 . ANSWER THE FOLLOWING QUESTIONS: A. to pay for fixed asset additions.780. Second. and ROE? Market values: Do investors like what they see as reflected in the P/E and M/B ratios? WHAT ARE COMPUTRON'S CURRENT AND QUICK RATIOS? WHAT DO THEY TELL YOU ABOUT THE COMPANY'S LIQUIDITY POSITION? ANSWER: Computron has $540. The ratio categories. because of its negative cash flow from operations.Chapter 2 ASSUME THAT YOU ARE DONNA JAMISON'S ASSISTANT. AND WHAT ARE THE FIVE MAJOR CATEGORIES OF RATIOS? ANSWER: Financial ratios are used to get an idea about how well the company is being operated.and short-term debt to cover its operating cash outlays. note that the firm’s net operating cash flow is -$73. Even after all this borrowing. 5. First. AND THAT SHE HAS ASKED YOU TO HELP HER PREPARE A REPORT THAT EVALUATES THE COMPANY’S FINANCIAL CONDITION. and where it needs improving.180 in long. 2.600 during 2009. WHAT IS THE PURPOSE OF FINANCIAL RATIO ANALYSIS. are as follows: 1. easy-to-use measures of liquidity: C urrent ratio= C urrent assets $1. and their purposes. WHAT CAN YOU CONCLUDE ABOUT THE COMPANY’S FINANCIAL CONDITION FROM ITS STATEMENT OF CASH FLOWS? ANSWER: Begin by reviewing briefly what balance sheets and income statements are. 3. ROE. Computron had to borrow a total of $126. while the other items reflect differences between balance sheet accounts and thus show changes in those accounts between the two dates. but these two ratios provide quick. Then give an overview of the statement of cash flows. B. 4. Will it have trouble meeting its required payments? A full liquidity analysis requires a cash budget. Liquidity: Can the company make required payments in the short run (defined as the next year)? Asset management: Are the investments in assets about right in view of sales levels? Debt management (financing mix): Does the company have about the right amount of debt. = = 2. and dividends) come from the income statement. or is it over leveraged? Profitability: Are costs under good control as reflected in the profit margin.

600. D. . the firm would still need to raise some cash from the sale of inventories to meet its current claims.000)/2 = $775.8 indicates that even if receivables can be collected in full. but the inventory figure is for one point in time.0 days 17 .0x 5. This analysis raises the question of whether Computron is holding excess inventories (relative to its sales level).600 = 4. Computron could liquidate assets at only 1/2. or “turned over.7x 1.200 + $836. An average monthly figure would be best. A problem arises in calculating and analyzing inventory turnover.850.8 days 32. DAYS SALES OUTSTANDING.4 = 0.2x.Chapter 2 Qu ickra tio= C u rre na s s e ts In v e n to rie $1.6 days  Sales   $3. and the downward trend from 2008 is also worrisome.2 5 00 0 0 so . each item of Computron’s inventories was sold and then restocked. 2009 2. 2009 average inventories = ($715.000/$775.8x 2008 2.0 times.4. = = 0. If a firm’s sales are highly seasonal. and they are the assets on which losses are most likely to occur in the event of a forced sale.42 = 42% of book value and still pay off current creditors in full. and also whether any of its inventories is old and obsolete. hence worth less than its stated value. Computron’s quick ratio of 0. With a 2009 current ratio of 2. For Computron. Sales occur throughout the year. In general.3x 0. FIXED ASSETS TURNOVER. 2009 2008 Industry 3. it would be preferable to use an average inventory amount. 8 4 × C u rre nlia b ilitie t s $5 4 02 0 0 .9x 4. WHAT ARE COMPUTRON’S INVENTORY TURNOVER. but (beginning of year + end of year)/2 is better than a point value because it at least adjusts for sales trends. DSO = Accounts receivable $402.” 3.9 times during 2009. = = 3 .2 9 00 0 0− $8 3 60 0 0 t s .9 × In ve n to rie s $8 3 60 0 0 .250.8x Industry 2. or are experiencing a strong trend.0x Current ratio Quick ratio Computron’s current and quick ratios have both held steady from 2008 to 2009. so average inventory turnover for 2009 = $3.000 = = 37 .6 days Industry 36. but they are slightly below the industry average. AND TOTAL ASSETS TURNOVER RATIOS? HOW DOES THE FIRM’S UTILIZATION OF ASSETS STACK UP AGAINST THAT OF THE INDUSTRY? ANSWER: In ve n to ry u rn o ve=r T C o sto f g o o d s ld $3.000   360    360     DSO 2009 2008 37.8x Inventory turnover As a rough approximation.4x 0. This compares poorly with the industry average of 6. inventories are the least liquid of a firm’s current assets.

Note that. an average figure for receivables would be better than the end-of-year amount. the company is utilizing its fixed assets at the industry average level. but its total assets turnover is below average. so it looks bad. WHAT ARE THE FIRM’S DEBT.0x 2.67 × Net fixed assets $360.33 × Total assets $1. The DSO can also be compared with the firm’s credit terms. as with inventories.) E.000 TIE = 18 .800 2009 2008 10. if Computron’s sales terms called for payment within 30 days. (Note again that average values of fixed and total assets would provide a better indication of the assets actually used to generate sales for the year.000 = = 10. but its total assets turnover ratio has remained relatively constant at a level just below the industry average. by the 30th day.97 × Interest expense $76.Chapter 2 The days sales outstanding (DSO) represents the average length of time that the firm must wait after making a sale before it receives cash.000 = = 2.650. TIMES-INTEREST-EARNED.850. Fixed assets turnover = Sales $3. AND FIXED CHARGE COVERAGE RATIOS? HOW DOES COMPUTRON COMPARE TO THE INDUSTRY WITH RESPECT TO FINANCIAL LEVERAGE? WHAT CONCLUSIONS CAN YOU DRAW FROM THESE RATIOS? ANSWER: Debt ratio = Total debt $540.850. As indicated earlier.800 EBIT $149.800 Sales $3. To illustrate.6-day DSO would indicate that some customers are taking well in excess of the 30-day limit.3x INDUSTRY 10.6x Total assets turnover = Fixed assets turnover Total assets turnover Computron’s fixed assets turnover ratio has improved from 2008 to 2009 to reach the industry average.4% Total assets $1.3x 2.700 = = 1. Thus.7x 2. Computron might have excess inventories and receivables.650.600 = = 58. Computron’s DSO is above the industry average and is trending higher. because some presumably are paying on time. then a 37.200 + $424.7x 10. and this would lower the total assets turnover relative to the fixed assets turnover.

and the trend is up. is also used in practice. F.1% 2008 2. hence shown on the balance sheet at a low value even though the assets are really quite valuable and produce high income and cash flows. AND RETURN ON EQUITY (ROE). This indicates that its sales prices are relatively low. or both.5x 2. Computron probably would find it difficult to borrow additional funds at a reasonable cost without first raising more equity capital.4x Industry 50.000 2009 58. but if its assets are old and largely depreciated.6 × $76. this is a better measure of debt usage than the debt ratio.4% 2.41.0x 1. For example. RETURN ON ASSETS (ROA). the debt-to-equity ratio. and this. indicates high and possibly excessive use of debt. The fixed charge coverage (FCC) ratio is similar to the tie ratio.5% Computron’s profit margin is low and falling. Creditors have supplied over one-half the firm’s total financing. this points out that Computron uses substantially more fixed charge financing than the average firm in the industry.1x Debt ratio TIE FCC All three measures reflect the extent of debt usage. Computron’s debt-to-equity ratio for 2009 is 1.000 Profit margin 2009 1. then the debt ratio might be overstating the impact of the debt on the firm's riskiness.00 = 1. like the debt ratio. The tie ratio focuses on the firm's ability to cover its interest payments. In some situations. that its costs are relatively high.850 . a firm might show a high debt ratio. but it is more inclusive in that it recognizes that long-term lease contracts also represent fixed.700 + $40. however.6x 2009 54. contractual payments. net income available to common stockholders after preferred dividends have been paid is used to calculate profit margin.15 % Sales $3. so it probably would have trouble obtaining additional debt or lease financing. indicating that creditors have contributed $1.6% Industry 3. In Computron’s case. ITS PROFIT MARGIN.41 for each dollar of equity capital.T ) = $149.3x 2. depending on the purpose of the analysis.0% 2. 19 .220 = = 1. Computron’s debt ratio is above the industry average. and it is falling.8% 3. Computron’s 2009 FCC ratio is also below the industry average. Note also that there are many variations of the coverage ratios. Note that another leverage ratio. the 2009 tie is below the industry average and falling. Again.Chapter 2 Fixed charge = FCC = coverage EBIT + Lease payment Sinking fund payment Interest expense + Lease payments + (1 .000 + $40. ANSWER: Profit margin = Net income $44. Note that because we are primarily concerned with the profitability to common stockholders. but they focus on different aspects. CALCULATE AND DISCUSS THE FIRM’S PROFITABILITY RATIOS—THAT IS.

3 Industry 9. G. 20 .800 .Chapter 2 ROA = Net income $44. Computron’s stock sold for $6. CALCULATE COMPUTRON'S MARKET VALUE RATIOS--THAT IS. However. its reported earnings were $44.7% 6.988/100. from $8. and because they are poor.9x. one would anticipate that the company’s common stock has not been doing very well.00/$6.86 and a stock price of $6.00 = = 13. almost reaching the industry average.7x 1.00 = = 0.220 = = 2.44 % Common equity $685 .00 per share.00.86 2009 13. this was not caused by an increase in stock price—the price fell by almost 30 percent.4x P/E M/B The P/E ratio shows how much investors are willing to pay per dollar of reported profits.6x 0.0% 13. The m/B ratio gives another indication of how investors regard the company. Computron’s P/E ratio would be well below the industry average.50 to $6.87 × Book value per share $6.00/$0. and the result was a P/E ratio of $6.220 = = 6. and falling. With earnings normalized (averaged over several years).44 = 13.2x 1. for an M/B ratio of $6.86 = 0. ITS PRICE/EARNINGS RATIO AND ITS MARKET/BOOK RATIO. These are “bottom line” ratios.442 Market/boo k (M/B) ratio = Markert price per share $6.9x 2008 9. Computron had a book value (of equity) per share of $685. This is well below the 1.00. Rather.988 ROE = ROA ROE 2009 2.68 % Total assets $1 650 .000 = $0.44 per share. Net income $44.57 × Earnings per share $0. At the end of 2009.4 2008 6.220/100.4x industry average.000 = $6.3x Industry 14. In 2009. WHAT DO THESE RATIOS TELL YOU ABOUT INVESTORS' OPINIONS OF THE COMPANY? ANSWER: Price eanrings (P/E) ratio = Price per share $6. Good companies with consistently high rates of return on equity sell at higher multiples of book value than those with low returns.1% 18. which is not surprising given Computron’s poor ROE.6x.2 Computron’s ROA and ROE are substantially below the industry average. the P/E ratio rose because of the 2009 earnings decline—earnings fell by almost 50 percent from the 2008 level. indicating that investors view Computron as being riskier and/or as having poorer growth prospects than the average firm in the industry. Note that the firm’s P/E ratio actually improved from 2008 to 2009.

which presumably would raise net income.56 3. USE THE FOLLOWING SIMPLIFIED 2009 BALANCE SHEET TO SHOW. and it would almost certainly improve the coverage ratios. combining these items in the equation shows how the different factors interact to determine ROA and ROE. In any event.651 DEBT EQUITY TOTAL LIABILITIES AND EQUITY $ 965 686 $1. and (3) its assets utilization as measured by the total assets turnover. and that its total assets utilization is somewhat below average but holding steady.694. that reducing accounts receivable by 10 days of sales is not a cost-free action. That $106.651 ANSWER: Sales per day amount to $3.6 DAYS.6 = $295. which would lower shares outstanding and thus raise EPS.6 DAYS TO 27. IF THE COMPANY COULD IMPROVE ITS COLLECTION PROCEDURES AND THEREBY LOWER THE DSO FROM 37. DuPont Equation: 2009: 2008: Industry: Profit margin (profit/sales) 1.000.15% 2. HOW AN IMPROVEMENT IN ONE OF THE RATIOS— SAY. Accounts receivable are now $402.0 9. hence DPS. The data for Computron and the industry are given below.7% 6.850. down $106. The change also might improve the risk picture as reflected in the debt ratio (if the $106. HOW WOULD THAT CHANGE “RIPPLE THROUGH” THE FINANCIAL STATEMENTS (SHOWN IN THOUSANDS BELOW) AND INFLUENCE THE STOCK PRICE? ACCOUNTS RECEIVABLE $ 402 OTHER CURRENT ASSETS 888 NET FIXED ASSETS 361 TOTAL ASSETS $1. WHAT ARE SOME PROBLEMS AND LIMITATIONS? .1 We see that Computron’s expense control as reflected in the profit margin is both poor and trending down. EPS.6 x x x x = = = = ROA 2. These measures combine to produce an ROA that is very low and falling. If A/R can be reduced to 27. however. This would lower the firm’s J.Chapter 2 H. USE THE DUPONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW OF COMPUTRON’S FINANCIAL CONDITION.154. I. (Note.34 2.6 days without affecting sales. (2) its expense control as measured by the profit margin. or 37. FOR EXAMPLE.50 Total assets turnover (Sales/TA) 2. (2) to buy back stock.6 days’ sales. THE DSO—WOULD AFFECT THE STOCK PRICE.694 x 27.33 2. AND IT MUST BE USED WITH CARE AND 21 JUDGMENT. which would lower interest charges and thus increase profits. IN GENERAL TERMS. perceivedALTHOUGH of this would improve the stockANALYSIS CAN PROVIDE USEFUL riskiness. or (3) to invest in productive assets. should increase.846 could be used (1) to reduce debt. THIS TYPE OF ANALYSIS DOES HAVE SOME POTENTIAL PROBLEMS AND LIMITATIONS.000/360 = $10. WHAT ARE THE FIRM’S MAJOR STRENGTHS AND WEAKNESSES? ANSWER: The DuPont equation provides an overview of (1) a firm’s profitability as measured by ROA and ROE.) OPERATIONS AND ITS FINANCIAL INFORMATION ABOUT A COMPANY’S CONDITION.846 were used to reduce debt). All FINANCIAL STATEMENT price.846 from the current level. then the balance sheet item A/R would be $10.

Inflation distorts firms’ balance sheets. (1) Many large firms operate a number of different divisions in quite different industries. a high fixed assets turnover ratio can occur either because a firm uses its assets efficiently or because it is undercapitalized and simply cannot afford to buy enough assets. This improved his current and quick ratios. multi-divisional ones. if one firm leases a substantial amount of its productive equipment. and then paid off the loan ahead of time on January 5. which is good. Seasonal factors can also distort ratio analysis. Most firms want to be better than average. it is preferable to target on the industry leaders' ratios. which is bad. For example. This tends to make ratio analysis more useful for small. must be interpreted with care and judgment. Thus. and made his year-end 2006 balance sheet look good. because leased assets often do not appear on the balance sheet. However.Chapter 2 ANSWER: Some of the problems and limitations of financial statement analysis are discussed below. 22 (2) (3) (4) (5) (6) (7) (8) . A firm might have some ratios that look “good” and others that look “bad. Thus. classify companies according to their probability of getting into financial distress. However. a Chicago builder borrowed on a two-year basis on December 29. in a strong or a weak position. narrowly-focused firms than for large. because excess cash in the bank is a non-earning asset. Different operating and accounting practices can distort comparisons. profits also are affected. the lease liability might not be shown as a debt. Further. As noted earlier. statistical procedures can be used to analyze the net effects of a set of ratios. Also. the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventories is the one just before versus the one just after the canning season. a high current ratio might indicate a strong liquidity position. on balance. because inflation affects both depreciation charges and inventory costs. Similarly. held the proceeds of the loan as cash for a few days. so merely attaining average performance is not necessarily good. 2009. inventory valuation and depreciation methods can affect the financial statements and thus distort comparisons among firms that use different accounting procedures. Firms can employ “window dressing” techniques to make their financial statements look better to credit analysts.” making it difficult to tell whether the company is. or a comparative analysis of firms of different ages. 2006. or excessive cash. To illustrate. It is difficult to generalize about whether a particular ratio is “good” or “bad. on the basis of their analyses. and in such cases it is difficult to develop a meaningful set of industry averages for comparative purposes. a ratio analysis for one firm over time. the improvement was strictly temporary. a week later the balance sheet was back at the old level.” For example. then it might show relatively few assets in comparison to its sales. leasing can artificially improve both the debt and turnover ratios. To achieve high-level performance. This problem can be minimized by using monthly averages for inventories when calculating ratios such as turnover. Many banks and other lending organizations use these procedures to analyze firms' financial ratios and. At the same time.

and its stock price is anticipated to double.290 575.527 395. There still is room for improvement.S. T.5 10.935 6. n.000 325.95 Under these new conditions.a.0 2. earnings Income statement Sales Cost of G.527 168. INPUT DATA: $ $ 1.9 33 8.0% 4.A.A.2% $7. Accts & Notes Pay.000 238.000 134.9% 47. Our real interest.152 $ 4.1% 18.450.000 3.68 6. Cary Corporation looks much better.0 23. Adm.000 248.0 n. KEY OUTPUT: 2010 23 INPUT DATA: Cary Industry . & sales exp. In the next chapter.3 2.000 $ $ 178. to see how well the company has been run. the profit ratios are quite high and the stock price has risen to $66. turn.8 32 13. 2-18 Computer-Related Problem a. Its turnover ratios are still low. we looked at financial statements from a historical perspective. of shares Cash dividend $ 84.237 Quick Current Inv.000 0.2% 50.0 4.699. DSO F. Net income P/E ratio No.527 $ 1. turn.000 120.290.0 2. The revised data and ratios are shown below: KEY OUTPUT: 2010 Cash A/R Inventories Land and bldg Machinery Other F.699. Accruals Long-term debt Common stock Retained earnings Total assets Total claims 2008 Ret.000 404.5% 19.6 9.2 3. ROA ROE TD/TA PM EPS Stock Price P/E ratio M/B Cary 1. As you can see. we go on to forecast financial statements to get an idea of where the firm will be going in the future. is in the future.000 275.000 700. 6.a.775 159.a. Depreciation Misc.A.000 are shown next. its estimated P/E ratio is better.000 132. b.24. but its ROA and ROE are above the industry average.000 150.Chapter 2 Conclusion: In this chapter.7 5.78 $46. though. but the company is in much better shape.19 Industry 1. turn.5% n. The financial statements and ratios for the scenario in which the cost of goods sold decreases by an additional $125.0 1.0% 3.

Accts & Notes Pay.A. EPS would fall to $4.237 Industry 1.000 250.527 $ 1.000 120.0 0.0 1.774.775 159.A.527 395.935 6. DSO F.52 $27.A.95 Quick Current Inv.6 9.4% $4.000 700.4 14.0% 3.a. The ROE would drop to 12.11. 6.3 2.290 575. n.000 238. Accruals Long-term debt Common stock Retained earnings Total assets Total claims $ 9.6% 49.0% 5.624.2 4. turn.a.9% $11. Depreciation Misc.000 120. & sales exp. ROA ROE TD/TA PM EPS Stock Price P/E ratio M/B 1.0 n. The financial statements and ratios for the scenario in which the cost of goods sold increases by $125.4 3. $ $ 1.11 6.S. Adm. As you can see.7 5. and the M/B ratio would be only 0.Chapter 2 Cash A/R Inventories Land and bldg Machinery Other F.5% n.2% 50.000 $ $ 253. Accruals Long-term debt Common stock Retained earnings Total assets Total claims 2008 Ret.a.52.5% n. turn.237 $ $ 1.000 275. turn.527 1.0% 3.000 248.000 150.0 23.000 3.000 275.152 $ 4. T.0 2. T.000 150.24 6. turn.04 $66. turn.774.527 395.8 5. of shares Cash dividend c.1 33 8.a.0% 45.000 132.000 404.000 238.4% 12.2% 50. ROA ROE TD/TA PM EPS Stock Price P/E ratio M/B 24 INPUT DATA: Cash A/R Inventories Land and bldg Machinery Other F. n. turn.a.56 1.000 over the revised estimate are shown next. KEY OUTPUT: 2010 Cary Quick Current Inv. profits would decline sharply.000 400. the stock price would drop to $27. Accts & Notes Pay.76. DSO F. 6.527 $ 1.6 9.290.0 2. $ 159.A.6 percent.2% 2.8 33 8.6 6.a.1% 18.000 134.000 404.3% 26.0 2.7 5.A.0 n.3 2.A. Net income P/E ratio No.0 2.527 168.290 575.624.8 32 13.000 132.000 700.000 0.1% 18.0 2.8 32 13. earnings Income statement Sales Cost of G.76 .325.

168. & sales exp. such as the purchase of a new asset.000 0. A firm can analyze its financial ratios under different scenarios to see what might happen if a decision. 25 .152 $ 4.000 248.575. Net income P/E ratio No.935 6.290.S. This gives the managers some idea about what might happen under the best and worst cases and helps them to make better decisions.775 159.000 3. Depreciation Misc.0 23. Adm. did not produce the expected results.Chapter 2 2008 Ret.000 134. earnings Income statement Sales Cost of G. of shares Cash dividend d.95 Computer models allow us to analyze quickly the impact of operating and financial decisions on the firm's overall performance.000 $ $ 103.

If the financial manager actually intends to artificially inflate DEW’s profits this year. Discussion questions: ● What is the ethical dilemma? Discussion about this question can be fueled by asking some additional questions: Is it unethical for DEW to change its distribution system if the reason is to artificially inflate profits? Would it be unethical if the decision was made for the purposes of eliminating inefficiencies in the distribution process? ● Should DEW change its distribution system? Most would agree that DEW should not change its distribution system if the intent is simply to artificially inflate earnings in the current period. if the purpose for the change is to increase inventory efficiency. the change should decrease the cost of holding (carrying) inventory because the levels of inventory held by DEW will decrease. AN INCREASE IN SALES! Ethical dilemma: Dynamic Energy Wares (DEW) has decided to change the manner in which it distributes its products to large companies. but it appears to be the primary impetus for the decision. 26 . The change in the distribution system comes at a time when DEW’s profits are declining. If such actions do not adversely affect demand for its products.ETHICAL DILEMMA HOCUS-POCUS—LOOK. if the demand for DEW’s products actually is decreasing. For example. and any unsold inventory can be returned after nine months. they should be carried out. It also appears that the new policy requiring DEW’s distributors to increase inventory levels before the end of the fiscal year will artificially inflate DEW’s sales for the current year. So. she must realize that such actions eventually will “catch up” with her. In fact. the impact will appear on next year’s financial statements. because investors as a whole generally recognize such tactics for what they really are—“smoke screens. then it probably is a wise decision. However.” On the other hand. The declining profits might not be the sole reason for the change. empirical studies indicate that such actions are useless if the purpose is to make the company look good to investors. DEW’s new policy does not require the distributors to pay for any increased inventory until next year (six months).

The fact that senior management has decided to form a task force to examine and recommend ways to improve its market share is a step in the right direction. But. Such action indicates that DEW wants to find a long-run solution to its declining profits. Inc. most students will express discomfort with the prospect of having to overtly mislead others. the other involved PerSeptive Biosystems. Now. the CEO’s performance bonus was cut to zero. you will find that some of the students change their minds. 16+. the company had to repurchase much of this excess inventory because it could not be sold by the distributors.” Financial World. Additional information concerning Bausch & Lomb's decision to change its distribution system can be found in the following articles: “Bausch & Lomb: Clouded Vision. Redirect the discussion by asking the students what strategy they would follow if they actually did attend the distributors’ meeting. But. Midway through 1994. ● Would you go to the distributors’ meeting? What should you tell the distributors? If there is no penalty for declining to attend the distributors’ meeting. Bausch & Lomb instituted a change in its distribution system that helped reduce inventories significantly and allowed the company to post a $10 million gain for the quarter. Because of the poor performance of Bausch & Lomb in 1994. however. you probably will find the discussion has an underlying theme—while many believe it is part of the business world. DEW needs to come up with a solution that will stabilize or improve earnings in the long run. In the last quarter of 1993. the financial manager. 1995. During the year. ask them what they would do if their boss. 27 . most students would tell you they would prefer to stay home. which is a well-known eyewear company. Discuss some additional steps (actions) DEW can take to improve its financial position and to remain competitive.● What should DEW do? It appears that DEW needs some changes because profits have been declining during the past year. said they had to attend the meeting or lose their well-paying job. p. References: There have been many reports of firms that have followed a strategy similar to that described in this chapter's ethical dilemma. Bausch & Lomb estimated its distributors had excess inventory equal to $75 million. May 23. which produces instruments used in biotechnology analysis. Would they try to mislead the distributors if they believed DEW’s decision to change the distribution system was made solely for the purpose of artificially increasing profits? What tact would be taken if they believed the decision ultimately would improve inventory efficiency for both DEW and the distributors? How would distributors concerns be handled? The answers to these questions will be varied.. A couple of classic examples occurred in 1994—one involved Bausch & Lomb. A quick. temporary “fix” is not an appropriate solution—it just delays the inevitable.

"SEC Probes Telxon’s Accounting Practices. A3. Unusual Securities Trading. p. PerSeptive's management stated the strategy was to increase renewable sales by allowing the market to experience its product firsthand before requiring a purchase commitment. Reversing Some Accounting Maneuvers. 1994. February 22. p. to prospective customers on a trial basis. “Bausch & Lomb's Myopia.000. 1994. It was reported that PerSeptive would offer its diagnostic equipment. p. Even though the trial offers were not technically considered sales. 1994." Barron’s. 108+. 47. May 19. 28 . At the time. 1994. For the quarter ending September 30. "More Second-Guessing: Markets Need Better Disclosure of Earnings Management. August 24. 1999. including the famous Enron situation. 1B. November 8. June 2. p." The Wall Street Journal." Dow Jones Business News. 1998." The Wall Street Journal. p. there are quite a few examples of “misjudgments” in the applications of accounting practices that have been reported in recent times.” Forbes. "Biotech Company Is Questioned About 'Try It Out' Sales Strategy." USA Today. "Rite Aid Restates Year Net Downward. 1998. December 28. 14+. B1+.” Business Week. the following articles might be helpful: "PerSeptive Restates Its Results for Much of Past 2 Fiscal Years. p. in some instances. December 5. 1994. some of which cost in excess of $50. PerSeptive recorded them as sales and corresponding receivables. "Enterprise: Tech Concerns Fudge Figures to Buoy Stocks. p. December 19. B1+. For more information about PerSeptive and this situation. requiring payment at some later date only if the equipment was found to be desirable." The Wall Street Journal. As you know. 1994. 1999. Its “free trial” offer did not generate the renewable sales that it hoped.“Bad Math at Bausch & Lomb?. Recent articles that relate these misjudgments include the following: "Accounting Abracadabra: Cooking the Books Proves Common Trick of the Trade." The Wall Street Journal. PerSeptive posted nearly a $21 million loss because it wrote off a large amount of inventory and had to reduce accounts receivable significantly. August 11.

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