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# Chapter 18 - Financial Analysis

CHAPTER 18
Financial Analysis
Answers to Problem Sets
1.
Cash
Accounts receivable

\$
thousands
25
35

Inventories
Total current assets
Net plant & equipment
Total assets

30
90
140
230

2

\$ thousands
Accounts payable
Total current
liabilities
Long-term debt
Equity

24
24

Total liabilities & equity

230

130
75

a.

ROA = (((1 - .35) x 67 + 474)/4,126 = .125, or 12.5%

b.

Operating profit margin = ((1 - .35) x 67 + 474)/ 7,911 = .065, or 6.5%

c.

Sales-to-assets = 7,911/ 4,126 = 1.9

d.

Inventory turnover = 1,997/ 856 = 2.3

e.

Debt-to-equity ratio = 1,078/ 1,653 = .65

f.

Current ratio = 2,787/ 1,699 = 1.64

g.

Quick ratio = (402 + 1,034)/ 1,699 = .85

18-1

0 Total shareholders’ depreciation equity Net tangible fixed assets 20.9 Taxable income 9.220 million b.3 taxes Interest expense .653) = .9 21. Market-to-book = 195 x \$45.2 Earnings before interest & 10.8 Long-term investments .653)] = \$177.2 Long-term debt Total current assets 55.6 67. ROC = [(1-.50 / \$1.Financial Analysis 3. 2008 % Cash & marketable securities 8.0 4. Market-value-added = 195 x \$45.50 .Chapter 18 .653 = \$7.078 + 1.3 Net income 6.6 33.\$1.35) x 67 +474] – [.6 Accounts payable Inventories 19. general and 61. % 2.1 Total assets 100 Total liabilities & shareholders’ equity COMMON-SIZE INCOME STATEMENT.0 Debt due for repayment Accounts receivable 20. COMMON-SIZE BALANCE SHEET.10 x (1.0 33.4 Tax 3.5 Other long-term assets 23.2 Selling.3 administrative expenses Depreciation 3.0% 18-2 .7 Total current liabilities Other current assets 7.4 31.6 Other long-term liabilities Tangible fixed assets 47.190.5 11.0 100 a.078 + 1.653 = 5. or 19.35) x 67 +474] / (1. 2008 Sales 100% Cost of goods sold 25.7 million d. EVA = [(1-.4 c.8 Total liabilities Less accumulated 27.

000 = . The correct definitions are: a. 9. b.500/300.25.   18-3 ..73.000 = 120.65% 10.   . Sales = 3 X 500. 1. d.000 = 24% b. after-tax interest + net income = .   8.000 – (1.000 = 1.000.08 X 3 X 500.Chapter 18 . c. e. f.500. a. The illogical ratios are a. and i.500.. ROE = net income/ equity = 100. Net working capital = 40.000 = 100. Total capitalization = 540. a.47 b.52. ROA = 120.000/500.08 X 1. Net income = . Debt to total capitalization = . False True False False False—it will tend to increase the price–earnings multiple.35) X 30.34    7.Financial Analysis   5. b. 6.   .000.500. 3. c.

Chapter 18 .Financial Analysis 18-4 .

50. As discussed in Section 21-3. there are many different ways to measure a firm’s overall performance. derivatives positions. Assume that new debt is current liability. The following are examples of items that may not be shown on the company’s books: intangible assets. a. It can also make debt ratios seem high. off-balance sheet debt. Long-term debt ratio is unchanged.6935 12. This affects accounting rates of return because book assets are too low. again because assets are undervalued. a. Some of the financial metrics include: Market value added – the difference between the amount of money shareholders have invested in the firm and current market capitalization of equity.67 to 120/80 = 1. Current ratio goes from 100/60 = 1. pension assets and liabilities (if the pension plan has a surplus).63 b.5 to 50/80 = . \$82 million . This ratio gives us a common-size basis for comparing smaller and larger firms.6833 to 430/620 = . The value of intangible assets generally does not show up on the company’s balance sheet.Financial Analysis 11. b. Return on equity – the net income divided by equity 18-5 . 15.Chapter 18 . Patents and trademarks. Return on capital – the total profits available for all investors (equity and debtholders) divided by the amount of money invested in the firm. cash ratio goes from 30/60 = . Market-to-book ratio – the market value of equity divided by book value of equity. are not recorded as assets unless they are acquired from another company. Research and development expenditures are generally recorded as expenses rather than assets. 13. 14. Economic value added – the profit for the firm after the cost of capital is deducted. thereby understating income and understating assets. total liabilities/total assets goes from 410/600 = . which can be extremely valuable assets. \$10 million.

Financial Analysis Return on assets – (after tax interest plus net income) divided by total assets Each of these measures has its advantages. The answer.000 ten years from now is worth less than a certain payment of \$1. the use of book values may be an acceptable proxy. as far as lenders are concerned.” For most purposes. In all cases we may wish to compare recent performance with historical firm performance and with contemporary performance of comparable firms in order to judge whether performance was satisfactory. How you treat preferred stock depends upon what you are trying to measure. preferred stock is a junior claim on firm assets. as in all questions pertaining to financial ratios.e.g. 16. if the information is available. you are interested in what a firm has promised to pay. not necessarily in what investors think that promise is worth. the pension fund. e. (Merton refers to this measure as the quasi-debt ratio. say. Preferred stock is largely a fixed charge that accentuates the risk of the common stock. On the other hand. After all. since intangible assets may be worthless in the event of financial distress. a financial manager is concerned with the market value of the assets supporting the debt. if you are concerned with. it may be helpful to discount face value at the risk-free rate. 18-6 . a certain payment of \$1. Looking at the face value of debt may be misleading when comparing firms with debt having different maturities. calculate the present value of the exercise price on the option to default. probability of default. i.. EVA and the rates of return show current performance and are not impacted by expectations of future events that are measured in current market prices.) You should not exclude items just because they are off-balance-sheet. depending on the goal of the analysis. However. e. “It depends on what you want to use the measure for.Chapter 18 . is. but. but you need to recognize that there may be other offsetting off-balance-sheet items.g. Therefore. You may need to look at the market value of debt.. The potential downside of these metrics is that they are grounded in book value and balance sheet figures that may not reflect economic reality accurately.000 next year.. when calculating the weighted average cost of capital.

The smaller denominator thus causes an increase in the times-interest earned ratio. giving the appearance of greater leverage. assets will be \$70. Of course the firm’s capital structure has not changed.14 0. The firm uses cash to purchase additional inventories  no effect After the merger. Inventory is sold  no effect b.20 1. Before the merger. interest payments will drop on the floating debt. suggesting an advantage of using book values for debt ratios.0  Cash + Accounts receivable = current liabilities = 55  Accounts receivable = 44 Total current assets = 77 = Cash + Accounts receivable + Inventory  18-7 .00 0. Balance Sheet Total liabilities + Equity = 235  Total assets = 235 Total current liabilities = 30 + 25 = 55 Current ratio = 1.2  55 = 11 Quick ratio = 1.10 0. 19. the cost of goods sold will be: (\$90 – \$20 + \$16) = \$86 With sales of \$100.2  Cash = 0. A customer pays its overdue bills  no effect e. profit will be \$14. The market value of the fixed-rate debt will increase with the decline in interest rates. The firm takes out a bank loan to pay its suppliers  no effect c.4  Total current assets = 1. therefore.4  55 = 77 Cash ratio = 0.00 0. Federal’s cost of goods includes the \$20 it purchases from Sara. The effect on the current ratio of the following transactions: a. and Sara’s cost of goods sold is: (\$20 – \$4) = \$16 After the merger.43 0. This will cause the ratio of market value of debt to equity to increase. 20. The firm arranges a line of credit  no effect d. sales will be \$100.Financial Analysis 17.20 0. With the interest rate decrease. 18. and profit will be \$14. The financial ratios for the firms are: Sales-to-Assets Profit Margin ROA Federal Stores Sara Togas Merged Firm 2.Chapter 18 .20 1. but in another it is somewhat complicated.20 Note that the calculation of profit is straightforward in one sense. Times-interest earned equals EBIT / interest payments.

2 = Average receivables/(Sales/365)  Sales = 200 EBIT = 200 – 120 – 10 – 20 = 50 Times-interest-earned = 6.Chapter 18 .84 24.4 = Long-term debt/(Long-term debt + Equity)  Long-term debt = 72 Equity = 180 – 72 = 108 Income Statement Average inventory = (22 + 26)/2 = 24 Inventory turnover = 5.20 38.0 120.80 13.0 = (Cost of goods sold/Average inventory)  Cost of goods sold = 120 Average receivables = (34 + 44)/2 = 39 Receivables’ collection period = 71. and Administrative Depreciation EBIT Equity Long-term debt Notes payable Accounts payable Total current liabilities TOTAL \$108 72 30 25 55 \$235 Interest Earnings before tax Tax Available for common Two obvious choices are: a. general.0 20.Earnings available for common stock = 38.Financial Analysis Inventory = 22 Total assets = Total current assets + Fixed assets = 235  Fixed assets = 158 Long-term debt + Equity = 235 – 55 = 180 Debt ratio = 0.0 50.25 = (EBIT + Depreciation)/Interest  Interest = 11.96  13.96 Tax = Earnings before tax .96 .8 Average equity = (108 + 100)/2 = 104 Return on equity = 0.8-24.2 = 38.84 The result is: 21. Total industry EBIT over total industry interest payments: 18-8 200.2 Earnings before tax = 50 – 11.24 = Earnings available for common stock/average equity  Earnings available for common stockholders = 24.0 10. Fixed assets Cash Accounts receivable Inventory Total current assets TOTAL \$158 11 44 22 77 \$235 Sales Cost of goods sold Selling.0 11.

Chapter 18 .Financial Analysis 18-9 .

Financial Analysis Company EBIT Interest Pmt A 10 5 B 30 15 C 100 50 D -3. the value of debt is affected. An alternative approach might be to adjust the cost of capital to account for the tax savings from debt. the second method gives too much weight to Company E. Presumably.Chapter 18 . inflation affects the value of inventory (and. 25. the value of debt (both longterm and short-term). Average of the individual companies’ ratios: Company EBIT Interest Pmt Times-interest A 10 5 2 B 30 15 2 C 100 50 2 Average times-interest-earned ratio = 16. Rapid inflation distorts virtually every item on a firm’s balance sheet and income statement. The presence of debt introduces more distortions. the method of calculation has a substantial impact on the result. 24. As mentioned above. 18-10 .5 E 80 1 80 Total 217 73 EBIT /interest payments = 217/73 = 2. although to varying degrees. Simply deducting the cost of equity from net income will not lead to the correct answer if the after-tax cost of debt differs significantly from the cost of equity—and if the firm has issued a meaningful amount of debt. hence. Here. but so is the rate demanded by bondholders. For example.0 2 -1.97 b. which is a large firm with little debt. and so on. who include the effects of inflation in their lending decisions. the relevance of the numbers recorded is greatly diminished.0 2 E 80 1 D -3.9 Clearly. Given these distortions. those ratios that relate directly to the variability of earnings and the behavior of the stock price have the strongest associations with market risk. the value of plant and equipment. Other accounting measures of risk might be devised by taking five-year averages of these ratios. cost of goods sold). 23. The first method is generally preferable. All of the financial ratios are likely to be helpful. Answers will vary depending on companies and industries chosen. When calculating EVA we should deduct the income tax shield in order to measure the true cost to the firm of raising capital via debt. 22. likely candidates include the debt-equity ratio and the P/E ratio.

and the unfunded pension liability) are included in the calculation would depend on the time horizon of interest. the amount of money that has been contributed to the firm by investors does not change during the year. By contrast. deferred taxes. short-term accounts. the key question is: What is the maturity of this debt relative to the obligations represented by these accounts? If the debt has a shorter maturity. Using an average of capital at the start and end of the year for the denominator will produce a reasonable result if the firm actively increases or reduces capital over the year in a manner consistent with past practices. by definition. the bank loan would not be included in debt. Because both current assets and current liabilities are. then they should be included. then they should not be included because the debt is. a senior obligation. R&R reserve. If the debt has a longer maturity.e.Financial Analysis 26. It is calculated as (after-tax interest + net income) / total capital. All of these accounts represent long-term obligations of the firm. 27. Having done this. if increases in capital over the year occur without additional debt or stock issuances (such as solely through retained earnings).Chapter 18 . Whether or not the other accounts (i. [It may be of interest to note here that some companies have recently issued debt with a maturity of 100 years. ‘netting’ them out against each other and then calculating the ratio in terms of total capitalization is preferable when evaluating the safety of long-term debt.] 18-11 . Using an average that includes the higher year-end figure will overstate the amount of capital contributed and will likely understate the ROC calculation. Recall that return on capital (ROC) equals the total profits earned for debt and equity investors divided by the amount of money contributed.. If the goal is to evaluate the safety of Geomorph’s debt. in effect.