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# Chapter 4

Analysis of Financial Statements
Learning Objectives

After reading this chapter, students should be able to:

 Explain what ratio analysis is.
 List the five groups of ratios and identify, calculate, and interpret the key ratios in each
group. In addition, discuss each ratio’s relationship to the balance sheet and income
statement.

 Discuss why ROE is the key ratio under management’s control, how the other ratios
affect ROE, and explain how to use the DuPont equation to see how the ROE can be
improved.

 Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given
firm’s ratios over time (trend analysis).

 Discuss the tendency of ratios to fluctuate over time, which may or may not be
problematic. Explain how they can be influenced by accounting practices and other
factors and why they must be used with care.

Chapter 4: Analysis of Financial Statements

Learning Objectives

41

Lecture Suggestions

Chapter 4 shows how financial statements are analyzed to determine firms’ strengths and
weaknesses. On the basis of this information, management can take actions to exploit
strengths and correct weaknesses.
At Florida, we find a significant difference in preparation between our accounting and
non-accounting students. The accountants are relatively familiar with financial statements,
and they have covered in depth in their financial accounting course many of the ratios
discussed in Chapter 4. We pitch our lectures to the non-accountants, which means
concentrating on the use of statements and ratios, and the “big picture,” rather than on
details such as seasonal adjustments and the effects of different accounting procedures.
Details are important, but so are general principles, and there are courses other than the
introductory finance course where details can be addressed.
What we cover, and the way we cover it, can be seen by scanning the slides and
Integrated Case solution for Chapter 4, which appears at the end of this chapter solution.
For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2,
where we describe how we conduct our classes.
DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

42

Lecture Suggestions

Chapter 4: Analysis of Financial Statements

4-1

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 (stockholders) are interested primarily in profitability, but they
examine the other ratios to get information on the riskiness of equity commitments.
Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as
well as the profitability ratios. Short-term creditors emphasize liquidity and look most
carefully at the current ratio.

4-2

The inventory turnover ratio is important to a grocery store because of the much
larger inventory required and because some of that inventory is perishable. An
insurance company would have no inventory to speak of since its line of business is
selling insurance policies or other similar financial products—contracts written on
paper and entered into between the company and the insured. This question
demonstrates that the student should not take a routine approach to financial
analysis but rather should examine the business that he or she is analyzing.

4-3

Given that sales have not changed, a decrease in the total assets turnover means
that the company’s assets have increased. Also, the fact that the fixed assets
turnover ratio remained constant implies that the company increased its current
assets. Since the company’s current ratio increased, and yet, its cash and
equivalents and DSO are unchanged means that the company has increased its
inventories. This is also consistent with a decline in the total assets turnover ratio.

4-4

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. Also, profit margins and turnover ratios may vary due to differences in
the amount of expenses incurred to produce sales. For example, one would expect a
grocery store chain to spend more per dollar of sales than does a steel company.
Often, a large turnover will be associated with a low profit margin, and vice versa.

4-5

Inflation will cause earnings to increase, even if there is no increase in sales volume.
Yet, the book value of the assets that produced the sales and the annual depreciation
expense remain at historic values and do not reflect the actual cost of replacing
those assets. Thus, ratios that compare current flows with historic values become
distorted over time. For example, ROA will increase even though those assets are
generating the same sales volume.
When comparing different companies, the age of the assets will greatly affect the
ratios. Companies with assets that were purchased earlier will reflect lower asset
values than those that purchased assets later at inflated prices. Two firms with
similar physical assets and sales could have significantly different ROAs. Under
inflation, ratios will also reflect differences in the way firms treat inventories. As can
be seen, inflation affects both income statement and balance sheet items.

Chapter 4: Analysis of Financial Statements

43

4-10 44 Total Current Current Assets Ratio Effect on Net Income a. as well as current liabilities.4-6 ROE is calculated as the return on assets multiplied by the equity multiplier. so the calculated rate of return on equity will be different depending on whether end-of-year. One would not expect the three components of the discount merchandiser and high-end merchandiser to be the same even though their ROEs are identical. people are reported to have deliberately used end-of-year or beginning-of-year equity to make returns on equity appear excessive or inadequate. the lower its equity. beginning-ofyear. + + + f. those ratios that examine balance sheet figures will vary unless averages (monthly ones are best) are used. For example. such as Frito-Lay. Therefore. 2008. vary over the year for firms with seasonal sales patterns. say during 2008. The equity multiplier. A fixed asset is sold for more than book value. Answers and Solutions Chapter 4: Analysis of Financial Statements . comparing Pepsico and Coca-Cola may be misleading because apart from their soft drink business. A fixed asset is sold for less than book value. Pepsi also owns other businesses. while the assets turnover would be higher for the discount merchandiser than for the high-end merchandiser. b. Average common equity is conceptually the best figure to use. Cash is acquired through issuance of additional common stock. year-end equity will be much larger than beginning-of-year equity. Federal income tax due for the previous year is paid. 4-9 The three components of the DuPont equation are profit margin. + + 0 b. If a firm is growing rapidly. Short-term notes receivable are sold at a discount. say December 31. More fundamentally. using more debt will increase the equity multiplier. and inventories. the more debt a firm uses. and the higher the equity multiplier. + + – e. Thus. comparisons may be misleading if firms in the same industry differ in their other investments. Cash is obtained through short-term bank loans. 4-7 a. Payment is made to trade creditors for previous purchases. resulting in a higher ROE. Cash. is a measure of debt utilization. or average common equity is used as the denominator. 4-8 Firms within the same industry may employ different accounting techniques that make it difficult to compare financial ratios. A cash dividend is declared and paid. Profits are earned over time. – – 0 i. Merchandise is sold for cash. + + + c. Similar problems can arise when a firm is being evaluated. 0 – + d. receivables. + – 0 j. The discount merchandiser’s profit margin would be lower than the highend merchandiser. assets turnover. defined as total assets divided by common equity. – + 0 h. In public utility rate cases. and the equity multiplier. Common equity is determined at a point in time. – – – Merchandise is sold on credit. + + + g.

0 Equipment is purchased with short-term notes. 0 0 0 m. + – 0 t. 0 0 + p. The estimated taxes payable are increased. 0 – – n. Marketable securities are sold below cost. – Effect on Net Income Advances are made to employees. – – – 0 0 o. 0 – 0 s. Chapter 4: Analysis of Financial Statements Answers and Solutions 45 . Merchandise is purchased on credit. Accounts receivable are collected. 10-year notes are issued to pay off accounts payable. 0 0 0 q. 0 0 0 r.k. Short-term promissory notes are issued to trade creditors in exchange for past due accounts payable. – – Total Current Current Assets Ratio l. A fully depreciated asset is retired. Current operating expenses are paid.

000. ROA NI/A 10% S/TA = = = = PM  S/TA NI/S  S/TA 2%  S/TA TATO = 5. AR = ? AR DSO= S 365 AR \$7. CL = \$1.000.000.000. LT debt = \$3.000/365 40 = AR/\$20.33%.Solutions of End-of-Chapter Problems 4-1 DSO = 40 days.000.000.50.000 \$32.4 D = 0.000 = \$7.000. ROE NI/E 15% 15% TA/E = = = = = PM  S/TA  TA/E NI/S  S/TA  TA/E 2%  5  TA/E 10%  TA/E EM = 1.000.000. S = \$7. \$7.2667. Shares outstanding = 800.000.300.000 AR = \$800. M/B = ? Book value = M/B = 46 \$6.00 = 4.000.4. 40 = 4-2 A/E = 2. P0 = \$32.000.000.000.5833= 58.000.50 Answers and Solutions Chapter 4: Analysis of Financial Statements . PM = NI/S. TA/E = ? ROA = NI/A. TA = \$10.300. CE = \$6.000.5. S/TA = ?.000. ROE = 15%. A 4-3 4-4 ROA = 10%. PM = 2%.000.000. ROE = NI/E. 800. D/A = ? D  1  = 1   A  A/E  D  1  = 1   A  2.

077 323.00/\$50.0.4-5 EPS = \$2.148.000 8% = TA TA = \$7.00.2 = Step 2:Calculate net income.000.0.000.000  0.00.000.000/0.12 = NI/\$6.875.00 = 8.000  2 8%.875.4NI \$112.000. we still need EBIT.500.077) (Given) \$600.000 \$ 923.000.077 225.00.000 Chapter 4: Analysis of Financial Statements (\$225. 3. P/E = \$24.000 \$720.00/\$2.875. 4-6 PM = 2%.00 = 12.500 6.0. P/CF = 8. TA = ? NI TA \$600. Sales = \$6 million.0 P/\$3. There is 50% debt and 50% equity. Assets = \$50. To calculate EBIT construct a partial income statement: EBIT Interest EBT Taxes (35%) NI \$1.0 P = \$24. ROE = NI/S  S/TA  TA/E 0.000/\$937. EM = 2.000.500. 3.000.000. ROA = To calculate BEP. so Equity = \$1. CFPS = \$3.000.65 Answers and Solutions 47 . ROE = ? ROE = = = = 4-7 PM  TATO  EM NI/S  S/TA  A/E 2%  \$100.000  3.077 \$ 600.000.500 = NI. P/E = ? P/CF = 8.2  \$1.000 Assets Assets = \$1.12 = \$6.5 = \$937.000 + \$923.2 = Sales/TA \$6.000.4NI 0. Sales = \$100. 4-8 ROA = 8%. net income = \$600.000 = 6. Step 1:Calculate total assets from information given.000.

000.000 = 0. We are given ROA(NI/A) and ROE(NI/E). 48 Answers and Solutions Chapter 4: Analysis of Financial Statements .750.5. P = ? Total market value = \$3. D/A = 1 – 0.000.000.5) Profit margin = 3%/1.000.5 = 2%.50. Market value per share = \$75(1.148.077 \$7. Take reciprocal: E/TA = 3/5 = 60%.BEP = EBIT TA \$1.60 = 0.750.000. 4-10 We are given ROA = 3% and Sales/Total assets = 1.125.750.000/50.9) = \$142.125.750.000/50.000. given the facts of the problem. A D =1  0. M/B = 1. = 4-9 Stockholders’ equity = \$3.40= 40%. the firm’s profit margin = 2% and its debt ratio = 40%.000.40 = 40%.000(1.9) = \$7.31%.05 E = 60%. so A A NI A A E 1 = 3%  A 0.000. Market value per share = \$7. Shares outstanding = 50. ROA = Profit margin  Total assets turnover 3% = Profit margin(1.1531 = 15. P = ? Book value per share = \$3.000 = \$142.60= 0. if we use the reciprocal of ROE we have the following equation: E NI E D E =  and =1  .000.000.9. using the DuPont equation: ROE = ROA  EM 5% = 3%  EM EM = 5%/3% = 5/3 = TA/E. therefore.000.000 = \$75. From the DuPont equation: We can also calculate the company’s debt ratio in a similar manner. Thus.000.50.500.000. A Alternatively. Alternative solution: Stockholders’ equity = \$3.

000.000 = 2.000. Now we need to determine the inputs for the Du Pont equation from the data that were given.000/0. On the left we set up an income statement. EBIT = EBT + Interest = \$142.000/0.800.800.000.000.000.857.000/2 = \$5. and we put numbers in it on the right: Sales (given) – Cost EBIT (given) – INT (given) EBT – Taxes (34%) NI \$10. NI = 0.6 400.000.05 = \$100.000.000 EBIT = \$1.000.000.857.000 = \$192.000 \$ 462.1 = \$50. TA = S/2 = \$10. T = 40%. Pre-tax income (EBT) = \$100. EBIT INT EBT Taxes (40%) NI INT = EBIT – EBT \$1. 4-13 ROE = Profit margin  TA turnover  Equity multiplier = NI/Sales  Sales/TA  TA/Equity.000 na \$ 1.15 \$12.000.000.857 + \$50. Chapter 4: Analysis of Financial Statements Answers and Solutions 49 .000 300.000 See above.000 – \$1.000 See above.000.000.000.800.7 = \$142. 4-12 TIE = EBIT/INT.000.000  0.000 800.000 = 3.000.000.000 NI = \$600.000 Now we can use some ratios to get some more data: Total assets turnover = 2 = S/TA. Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.000/(1 – T) = \$100.000 238. = \$1.000.86. TIE = EBIT/INT = \$1.000.000.000 \$ 700.25.000. Interest = \$500.800.000 EBT = \$600.000.4-11 TA = \$12. so find EBIT and INT. TIE = \$192.000.000 \$ 600. Net income = \$2.000.000  0. ROA = 5%.857/\$50.000.000/\$800.000.05 \$12.000. EBIT/TA = 15%. TIE = ? EBIT = 0.000 \$1.000.000.000.000.

000.000.000. ROE will increase by 13. and the new Inventory level = \$150.2%. rate = 8%.000.5 = 0.5(\$50.1%. and.000 \$120.000 × 0. Equity multiplier = TA/E = 1/(E/A) = 1/0. *If D/A = 50%.000 generated is used to retire common equity.000.000 = 1.000. At an 8% interest rate. BEP = 0.000 = 12% \$1. If the \$85. This is the level of current assets that will produce a current ratio of 2.2% \$500.000 = \$65. so Debt = \$500. so EBIT = 0.000 – \$85.000* \$160.000 80.000.000.000) = \$200.4 = 2.000 = \$85.000 – \$85.000 = 19.000) = \$125. then the new common equity balance will be \$200.000 0 \$200. Answers and Solutions Chapter 4: Analysis of Financial Statements . Thus.000 \$96.000 40. (2) Adding assets will cause expected EBIT to increase by the amount EBIT = BEP(added assets).000 = \$115.5 = 50%. so they can be reduced by \$210. (3) Interest expense will increase by the amount Int. 4-14 Currently.000/\$10.000 = 7. so E/A = 40%. current assets amount to \$210.000 \$50.08 = \$40. the new quick ratio is calculated as follows: New quick ratio = CA  Inv CL \$125.000 \$120. At present. so Equity = \$500.04% – 7.000.2% – 12.000.5.2(\$1.000.231 = 23. Therefore.000/\$115.000 \$65. CL is \$50.5%.000  2. The new CA level is \$125. The current ratio will be set such that 2.000.D/A = 60%. EBIT Interest EBT Tax (40%) NI ROE = NI = Equity D/A = 0% \$200.000 = 13.000.000/\$200. CL remain at \$50.54%. INT = \$500.000 \$ 96. 4-16 50 Statement a is correct.000/\$5. Assuming that net income is unchanged.000. = 4-15 Known data: TA = \$1.000.5.000.5 = CA/CL.000. D/A = 0.000 64. Refer to the solution setup for Problem 4-15 and think about it this way: (1) Adding assets will not affect common equity if the assets are financed with debt.000 D/A = 50% \$200.2. T = 40%. therefore. Int. then half of the assets are financed by debt.50% = 5. Now we can complete the DuPont equation to determine ROE: ROE = \$462. the new ROE will be ROE 2 = \$15.2 = EBIT/Total assets.0% = 7.000 Difference in ROE = 19. and it will not change.000.000.04%.5(CL) = 2.000 – \$125. ROE is ROE1 = \$15. so we can solve to find the new level of current assets: CA = 2.000  \$10.

because the BEP ratio uses EBIT.000/\$83. c.666.333 EBT \$416. TIE = EBIT/INT = \$500. rate).667 EBT = \$250.rate(added assets).000 .000. rate > BEP. Chapter 4: Analysis of Financial Statements Answers and Solutions 51 . then adding assets financed by debt would lower net income and thus the ROE.312. Since we assumed that the additional funds would be used to increase inventory. Statements b.\$416. TIE ? EBIT  0.500 + NP = 2.500 = 2.05 \$5. \$525.0. (5) If expected net income increases but common equity is held constant. Statement e is also false. rate.575.000.000.0.000. if pre-tax income increases so will net income.000. and d are false. EBIT \$500. T = 40%.050. Statement a is true—if assets financed by debt are added.000 + NP \$1. and if the expected BEP on those assets exceeds the interest rate on debt.500. EBIT/TA = 10%. Of course.000.666. Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio. (4) Pre-tax income will rise by the amount (added assets)(BEP – Int.312.312.5.000 Minimum current ratio = \$1. NI  0.000. Therefore.333. INT = EBIT – EBT = \$500.000 See above.000.333.000 INT 83.000/0.000 EBIT  \$500.6 See above.000.500 + NP = \$1.500 and current assets will total \$1.000.500 without violating a 2 to 1 current ratio.000.500. \$525. then the firm’s ROE will increase.000 . which is calculated before the effects of taxes or interest charges are felt. Assuming BEP > Int.000.000 .000. Note that if Int.000 + 2NP NP = \$262. 4-18 Present current ratio = \$1.000.333 = 6.000. 4-17 TA = \$5.666. then the expected ROE will also increase. Short-term debt can increase by a maximum of \$262. and current liabilities will total \$787.667 NI \$250.667 Taxes (40%) 166.10 \$5.000 NI  \$250. assuming that the entire increase in notes payable is used to increase current assets. ROA = 5%. the inventory account will increase to \$637.

50)(Total assets) = (0. 9. Sales = (1.00.250.000) = \$450. the new sales level will be \$4. 52 Answers and Solutions Chapter 4: Analysis of Financial Statements .50)(\$300.000/500. 5.000 + \$90. + Inventories) = \$300. Accounts receivable = (Sales/365)(DSO) = (\$450. 8.75) = \$337. Cash + Accounts receivable + Inventories = (1.5) = \$45. 3.000.73. Again.000 shares or \$4.230.000. If the shares are selling for 10 times EPS.000/650.000 – \$150.000 = \$90.500. Total debt = (0.8)(\$90.85) = \$4. Thus.82  \$405.00.000 – \$60.681. 4-21 1.000) Cash + \$135. 2.977.000 = \$5.000 – \$97.000/(Sales/365) = \$273. 4-20 The current EPS is \$2. 7.000 = (1. Cost of goods sold = (Sales)(1 – 0.000. then they must be selling for \$5.750.000 + \$90.000 = \$162.977.82/365) 35= AR/\$11. 6. the new EPS = \$3.5)(Total assets) = (1.000 Cash = \$27.000 + \$45.00.000.000) = \$150.272.000/5 = \$90. solve for the new accounts receivable figure as follows: 35= AR/(\$4.000) = \$138.230. using the DSO equation. Fixed assets = Total assets – (Cash + Accts rec.73(0.272.91 AR = \$405.00(10) = \$50.590. 4.5)(\$300.000 – (\$27.500. Common stock = Total liabilitie s andequity – Debt – Retained earnings = \$300.82.8)(Accounts payable) Cash + \$45.25) = (\$450.500 = \$52.681.000/365)(36.000.000.4-19 Step 1:Solve for current annual sales using the DSO equation: 55 55Sales Sales = \$750.000.000.000. Inventories = Sales/5 = \$450. The new number of shares outstanding will be 650. Accounts payable = Total debt – Long-term debt = \$150.000)(0. Step 2:If sales fall by 15%.682. The current P/E ratio is then \$40/\$4 = 10.000 = \$4.681.

ROE = 1.000 \$4.9% 60.3 days b. So. c. Common equity/Total assets = 40%. For the firm.500 \$241.0% Total debt Total assets = \$586.300 \$361.0 \$655.9% 3.500 Currentassets Inventorie s = = 1.6% Netincome Commonequity = \$27. Note: To find the industry ratio of assets to common equity.000 \$241. The total assets turnover ratio is well below the industry average so sales should be increased.500 = 2. (Dollar amounts in thousands. d.607.) Firm Currentassets Currentliabilitie s DS O = = \$655.40 = 2.500 = 1.7 Sales Total assets = \$1. ROE = PM  T. While the company’s profit margin is higher than the industry average. The firm’s days sales outstanding ratio is more than twice as long as the industry average.5 = Total assets/Common equity. If 2008 represents a period of supernormal growth for the firm.2% Net income Total assets = \$27.300 \$947.607.11 = 35 days Sales Inventorie s = \$1. \$361.98 2. recognize that 1 – (Total debt/Total assets) = Common equity/Total assets. or both.607.500 = 61.7  \$947.2%  3  2. turnover  EM = 1.300 \$1.500 = 1.7% 1.66 6.500 \$947. and 1/0.000 Industry Average = 1.70 3.404.A.4-22 a.000 = 7.500 \$947.0 Netincome Sales = \$27.500 = 6. assets decreased.25 \$330.7%  1. indicating that the firm should tighten credit or enforce a more stringent collection policy. However.000 \$330. ratios based on this year will be distorted and a comparison between them and industry averages will have little meaning.3 Accountsreceivable Sales/365 = \$336.500 = 7.6%.0% 76.6% 9.5 = 9%. the company seems to be in an average liquidity position and financial leverage is similar to others in the industry. Potential investors who look only at 2008 ratios will be Chapter 4: Analysis of Financial Statements Answers and Solutions 53 .000 For the industry. its other profitability ratios are low compared to the industry—net income should be higher given the amount of equity and assets.000 Currentliabilitie s 1.

and a return to normal conditions in 2009 could hurt the firm’s stock price.00% Returnon totalassets = Netincome Total assets = \$27 \$450 = 6.3 days 24 days \$27 Netincome = = 8. Equity \$315 b.57%  8.77 3 Profit margin = Netincome Sales = \$27 \$795 = 3.4286 = 8.73 2 Debtto totalassets = Debt Total assets = \$135 \$450 = 30.5 \$4. turnover = Sales Total assets = \$795 \$450 = 1.  Lease pymts pymts = 9.00% 9. 4-23 a.00% = 6%  1.40% 3.46 9 Inventory turnover = Sales Inventorie s = 5 10 DSO = Accountsreceivable \$66 = Sales/365 \$795/365 F.5 INT  Princ. Firm Industry Average Current ratio = Currentassets Currentliabilitie s = \$303 \$111 = 2.5 = \$6.77  1. A.41 6 T. turnover = Sales Net fixedassets = \$795 \$147 = 5.86 % ROA  EM Returnon commonequity = Alternatively.00% 30.5 = 11 7 EBITDA coverage = EBITDA Leasepymts \$61.misled. ROE = = \$795 \$159 = 30. A.6%. ROE = Profit margin  Total assets turnover  Equity multiplier Total assets Netincome Sales =   Common equity Sales Total assets \$27 \$795 \$450 =   = 3.00 % Timesinterest = earned EBIT Interest = \$49.57% 12. \$795 \$450 \$315 54 Answers and Solutions Chapter 4: Analysis of Financial Statements .4286 = 8.6%.4%  1.

d.77 1.K. and common equity. Analysis of the DuPont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low.7 TA 1 EM = = = 1. Chapter 4: Analysis of Financial Statements Answers and Solutions 55 .0% 3. perhaps indicative of excess capacity. D E = TA TA 1 – 0.4286  1. as shown by a slightly lower-than-average fixed assets turnover ratio. as well as those based on sales. or the firm is carrying more assets than it needs to support its sales.4286* Comment Good Poor O.30 = 0. 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 the firm. many ratios might be distorted. 0. and strengthening the debt position. or if it grew rapidly during the year.Profit margin Total assets turnover Equity multiplier Firm 3.43.4% 1. this would generate funds that could be used to retire debt. It is possible to correct for such problems by using average rather than end-of-period figures. profits. receivables. thus reducing interest charges and improving profits.0 1. If the firm had a sharp seasonal sales pattern. EM = ROE/ROA = 12.4286 Industry 3. Ratios involving cash.4289  1. could be biased. e. However.43. and current liabilities.7 E *1– Alternatively. c. Either sales should be higher given the present level of assets. this is not nearly as clear-cut as the overinvestment in inventory. There might also be some excess investment in fixed assets. If the company’s inventory could be reduced. inventories.86%/9% = 1.

b Based on year-end balance sheet figures. this will make its current ratio look worse than what was calculated above.Comprehensive/Spreadsheet Problem Note to Instructors: The solution to this problem is not provided to students at the back of their text.11 2. however. and total assets turnover have improved from 2007 to 2008.89 13.43 1.6 1. In 2007. Corrigan's debt ratio has increased from 2007 to 2008.65 2. however. 4-24 2008 2007 Industry Avga 2. b. Corrigan's inventory turnover. they are still below industry averages. its DSO is somewhat higher. its current ratio is still below the industry average of 2. its DSO was close to the industry average.0 3.5 Ratio Analysis Liquidity Current ratio Asset Management Inventory turnoverb Days sales outstanding Fixed assets turnover c b b Total assets turnover Profitability Return on assets Return on equity Profit margin on sales Debt Management Debt ratio Market Value P/E ratio Price/cash flow ratio a Industry average ratios have been constant for the past 4 years. a. c.47 7.18 2. which is bad. The firm's days sales outstanding ratio has increased from 2007 to 2008—which is bad. its debt ratio was right at the industry average.7.5% 54.94 32 9. fixed assets turnover. c Calculation is based on a 365-day year.76% 11.84 7.0% 15.7 4.47% 2.43% 5.31 2.74 4.79 32.33 2.81% 49.60 5. If the firm's credit policy has not changed.81% 50. but in 2008 it is higher than the 56 Comprehensive/Spreadsheet Problem Statements Chapter 4: Analysis of Financial . If it does have uncollectible receivables.16 6.00% 2.0 37.0 2. In 2008. it needs to look at its receivables and determine whether it has any uncollectibles. Corrigan's liquidity position has improved from 2007 to 2008.64% 9.22% 0.1% 18. In 2007.2% 3. Instructors can access the Excel file on the textbook’s web site or the Instructor’s Resource CD.

increase sales. This would improve its profitability ratios and market value ratios. this would increase its net income. Corrigan's profitability ratios have declined substantially from 2007 to 2008. g. this would improve its current ratio—as this would reduce liabilities as well. the firm should strengthen its balance sheet by paying down liabilities. Corrigan should increase its net income by reducing costs.industry average. Corrigan's P/E ratio has increased from 2007 to 2008. Chapter 4: Analysis of Financial StatementsComprehensive/Spreadsheet Problem 57 . Corrigan needs to reduce costs to increase profit. and they are substantially below the industry averages. or both. Reducing costs and lowering inventory would also improve its debt ratio. and improve its asset management by either using less assets for the same amount of sales or increase sales. lower its debt ratio. e. Its P/CF ratio has declined from the prior year and is well below the industry average. The firm's total assets turnover has improved slightly from 2007 to 2008. If Corrigan initiated cost-cutting measures. This would also improve its inventory turnover and total assets turnover ratio. Looking at the extended DuPont equation. but only because its net income has declined significantly from the prior year. Corrigan needs to reduce its costs. Given its weak current and asset management ratios. but it's still below the industry average. The firm's equity multiplier has increased from 2007 to 2008 and is higher than the industry average. and improve its asset management. lower its debt ratio. d. If Corrigan also reduced its levels of inventory. Corrigan's profit margin is significantly lower than the industry average and it has declined substantially from 2007 to 2008. increase sales. f. These ratios reflect the same information as Corrigan's profitability ratios. This indicates that the firm's debt ratio is increasing and it is higher than the industry average.

together with industry average data.” Jamison examined monthly data for 2008 (not given in the case). sales have not been up to the forecasted level. D’Leon’s 2007 and 2008 balance sheets and income statements. and she detected an improving pattern during the year. In addition. the annual data look somewhat worse than final monthly data. and investors are concerned about the firm’s survival. a regional snack foods producer. Table IC 4-3 gives the company’s 2007 and 2008 financial ratios.” Thus far. Part II Financial Statement Analysis Part I of this case. Also..Integrated Case 4-25 D’Leon Inc. presented in Chapter 3. after an expansion program. Thus. D’Leon had increased plant capacity and undertaken a major marketing campaign in an attempt to “go national. costs were falling. costs have been higher than were projected. The 2009 projected financial statement data represent Jamison’s and Campo’s best guess for 2009 results. D’Leon’s chairman. assuming that some new financing is arranged to get the company “over the hump. and a large loss occurred in 2008 rather than the expected profit. discussed the situation of D’Leon Inc. it appears to be taking longer for the advertising program to get the message 58 Integrated Case Chapter 4: Analysis of Financial Statements . and large losses in the early months had turned to a small profit by December. its managers. As a result. Monthly sales were rising. who had the task of getting the company back into a sound financial position. together with projections for 2009. are given in Tables IC 4-1 and IC 4-2.. directors. Donna Jamison was brought in as assistant to Fred Campo.

800 Liabilities and Equity Accounts payable Notes payable Accruals 136.632 878. Jamison and Campo see hope for the company—provided it can survive in the short run.000 Gross fixed assets Less accumulated depreciation Net fixed assets Total assets 1.040 \$3.000 \$ 524.716. For these reasons.432 460.800 \$ \$ 436.800 300.160 \$ 939.000 146.287.160 380. and what actions should be taken.200 715.480 \$2.000 1.568 \$ 400.200 \$ 323.000 32.out.926.600 Long-term debt Common stock Retained earnings \$ 2008 2007 85.800 \$1. for the new sales offices to generate sales.202. not yes or no answers.282 632. In other words.124.592 57.144. Table IC 4-1.650.768 Integrated Case 59 .790 \$2.600 351.680. Balance Sheets 2009E Assets Cash Accounts receivable Inventories Total current assets 1. and for the new manufacturing facilities to operate efficiently.468. what it must do to regain its financial health.497.197.360 \$1.160 1.000 489.000 \$ 145.721. the lags between spending money and deriving benefits were longer than D’Leon’s managers had anticipated.152 1.000 1.600 200.802 \$ 1.592 491.112 \$ 7.000 203.808 408.120 \$ 817.200 \$ 344.160 636.600 \$1.176 Chapter 4: Analysis of Financial Statements 723. Provide clear explanations.432 460.176 231.866.950 263. Jamison must prepare an analysis of where the company is now. Your assignment is to help her answer the following questions.000 Total current liabilities 481.

60 Integrated Case Chapter 4: Analysis of Financial Statements .497.768 Total liabilities and equity 1.592 \$ \$3.352 \$ 492.800 \$1.152 \$2.592 \$ Note: “E” indicates estimated.468.866.952.Total equity 663. The 2009 data are forecasts.

900 43.220 7.17 250.600 2008 \$6.110 4.000 550.926 2.640 136.875. Chapter 4: Analysis of Financial Statements Integrated Case 61 .948) \$ 70.000 40.000 0 \$ \$ \$ \$ 0.000 0 \$ \$ \$ 18.00% 40.034.035.584 (106.Table IC 4-2. Income Statements Sales 3.648 116.809 12.428 Interest expense EBT 146.25 100.640 87.988 13.000 5.056 \$ 253.672 \$ \$ 609.014 (\$ \$ \$ \$ 0.960 (\$ 130.828 \$ 58.608 (\$ \$ 116.960 \$ 492.047.425.00% 40.602) 0.672 EBITDA 209.528.50 100.432.960 1.864.000 40.000 40.638 8.880 DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments 2009E \$7.784)a (\$ 160.008 \$ 422.328 Depreciation EBIT 190.00% 40. a The firm had sufficient taxable income in 2006 and 2007 to obtain its full tax refund in 2008.600 Taxes (40%) Net income EPS 0.000 519.222.992 5.000 Cost of goods sold 2.988) 2007 \$ 358.012 (\$ 266. The 2009 data are forecasts.220 6.992 \$6.000 0 Note: “E” indicates estimated.000 Other expenses Total operating costs excluding depreciation 3.176) \$ 1.988 \$6.960) \$ 169.

4 0.4 n.0 Inventory turnover Days sales outstanding (DSO)a Fixed assets turnover Total assets turnover Debt ratio TIE Operating margin Profit margin Basic earning power ROA ROE Price/earnings Market/book Book value per share 2008 2007 1.6 50. profitability.2% -2. and by stockholders to help forecast future earnings and dividends.4 10.2 2.3 5.5% 19.2% 14.7 0. Then.6% -32.0% 6.7% -4. and market value. 62 Integrated Case Chapter 4: Analysis of Financial Statements .8% -1.1 32.2 6.8 4.0 2. Ratio Analysis Industry 2009E Average Current Quick 1.5 \$4.8 37.5% -1. The five major categories of ratios are: liquidity.64 6.93 Note: “E indicates estimated.8% 4.2 7. by lenders to help evaluate the firm’s likelihood of repaying debts.1 82.3% 9.1% 9.0 -2. asset management.6% 13.3% 3.3 \$6.6% 2.0% 13.a. debt management.4 2.3 54. The 2009 data are forecasts.0 7.] Ratios are used by managers to help improve the firm’s performance.7 1.0 2.4 2.Table IC 4-3.2 2.0% 6. 4.6% -5.7 38. a Calculation is based on a 365-day year. show S4-6 and S4-7 here.3 0. A. Why are ratios useful? What are the five major categories of ratios? Answer: [S4-1 through S4-5 provide background information.1% 18.

842.112 – \$1. How does D’Leon’s utilization of assets stack up against other firms in its industry? Chapter 4: Analysis of Financial Statements Integrated Case 63 .800 = \$963.144.800 = 2. 2008.680.716.680. Would these different types of analysts have an equal interest in these liquidity ratios? Answer: [Show S4-8 and S4-9 here. and as projected for 2009? We often think of ratios as being useful (1) to managers to help run the business.632/\$1.800 = 0. However. Calculate D’Leon’s 2009 current and quick ratios based on the projected balance sheet and income statement data. and total assets turnover.144. both the current and quick ratios are well below the industry averages.144. (2) to bankers for credit analysis. Calculate the 2009 inventory turnover. fixed assets turnover. The company’s current and quick ratios are identical to its 2007 current and quick ratios.480)/\$1. Quick ratio09 = (Current assets – Inventories)/Current liabilities = (\$2. C.B.34. days sales outstanding (DSO). and (3) to stockholders for stock valuation. What can you say about the company’s liquidity positions in 2007. and they have improved from their 2008 levels.112/\$1.] Current ratio09 = Current assets/Current liabilities = \$2.

040 = 8. the firm’s 2009 total assets turnover ratio is only slightly below the 2008 level.000/(\$7.035.] Inventory turnover09 = Sales/Inventory = \$7. it is above the 2008 level.10. How does D’Leon compare with the industry with respect 64 Integrated Case Chapter 4: Analysis of Financial Statements . Calculate the 2009 debt and times-interest-earned ratios.55 days. (This might be due to the fact that D’Leon is an older firm than most other firms in the industry. DSO09 = Receivables/(Sales/365) = \$878.497. The firm’s fixed assets turnover ratio is below its 2007 level. or that D’Leon’s cost of fixed assets were lower than most firms in the industry. the firm’s fixed assets turnover is above the industry average. Total assets turnover09 = Sales/Total assets = \$7. However.716. The firm’s days sales outstanding ratio is above the industry average (which is bad).Answer: [Show S4-10 through S4-15 here. its fixed assets are older and thus have been depreciated more.600/\$1.035. The firm’s inventory turnover and total assets turnover ratios have been steadily declining.480 = 4.600/\$817.600/365) = 45.152 = 2. in which case.035. however. while its days sales outstanding has been steadily increasing (which is bad).035.01.61.) D. The firm’s inventory turnover and total assets turnover are below the industry average.600/\$3. Fixed assets turnover09= Sales/Net fixed assets = \$7. however.

152 = 7.600 = 3.to financial leverage? What can you conclude from these ratios? Answer: [Show S4-16 and S4-17 here.99%  13. Basic earning power09 = EBIT/Total assets = \$492.00%.144.152 = 44.584/\$1. profit margin.000)/\$3.952.17%. The firm’s TIE ratio is also greatly improved from its 2007 and 2008 levels and is above the industry average.035. and return on equity (ROE).648/\$70.04. basic earning power (BEP).648/\$3.584/\$7.008 = 7. Chapter 4: Analysis of Financial Statements Integrated Case 65 .352 = 12. ROA09 = Net income/Total assets = \$253.035.600 = 7.] Debt ratio09 = Total debt/Total assets = (\$1.25%.497.152 = 14. What can you say about these ratios? Answer: [Show S4-18 through S4-24 here. return on assets (ROA).09%.584/\$3. E. ROE09 = Net income/Common equity = \$253.648/\$7.60%.800 + \$400.0%. Profit margin09 = Net income/Sales = \$253. The firm’s debt ratio is much improved from 2008 and 2007. Calculate the 2009 operating margin.] Operating margin09 = EBIT/Sales = \$492. TIE09 = EBIT/Interest = \$492. and it is below the industry average (which is good).497.497.

0143. The P/E and M/B ratios are above the 2008 and 2007 levels but below the industry average.81.0) = \$12. F.584/250.352/250. Market/Book09 = Market price per share/Book value per share = \$12.17/\$1.0143 = 12.000 = \$1. While the firm’s basic earning power and ROA ratios are above 2007 and 2008 levels.81 = 1. Check: Price = EPS  P/E = \$1.000 = \$7.The firm’s operating margin is above 2007 and 2008 levels but slightly below the industry average. however.0. The firm’s profit margin is above 2007 and 2008 levels and slightly above the industry average.17. BVPS09 = Common equity/Shares outstanding = \$1. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Answer: [Show S4-25 and S4-26 here.17/\$7. they are still below the industry averages. Price/Earnings09 = Price per share/Earnings per share = \$12. it is slightly below its 2007 level and still well below the industry average. 66 Integrated Case Chapter 4: Analysis of Financial Statements .952.] EPS09 = Net income/Shares outstanding = \$253. Calculate the 2009 price/earnings ratio and market/book ratio.0143(12.56. The firm’s ROE ratio is greatly improved over its 2008 level.

and its debt ratio has been greatly reduced. Weaknesses: The firm’s current asset ratio is low.60%  2. most of its asset management ratios are poor (except fixed assets turnover).96%  13. Interest expense is lower because the firm’s debt ratio has been reduced. Strengths: The firm’s fixed assets turnover was above the industry average. What are the firm’s major strengths and weaknesses? Answer: [Show S4-27 and S4-28 here. most of its profitability ratios are low (except profit margin).0%. and its market value ratios are low. However.) The firm’s profit margin is slightly above the industry average. This improved profit margin could indicate that the firm has kept operating costs down as well as interest expense (as shown from the reduced debt ratio). which has improved the firm’s TIE ratio so that it is now above the industry average. so it is now below the industry average (which is good). if the firm’s assets were older than other firms in its industry this could possibly account for the higher ratio. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2009.G.4417) = 12. (D’Leon’s fixed assets would have a lower historical cost and would have been depreciated for longer periods of time.01  1/(1 – 0.] DuPont equation Equity Profit Totalassets = margin  turnover  multiplier = 3. Chapter 4: Analysis of Financial Statements Integrated Case 67 .

H.952 Liabilities plus equity \$3.545 Equity 1.6 days to the 32-day industry average without affecting sales.497 68 Integrated Case Chapter 4: Analysis of Financial Statements . if the company could improve its collection procedures and thereby lower its DSO from 45. how would that change “ripple through” the financial statements (shown in thousands below) and influence the stock price? Accounts receivable \$ 878 Other current assets 1. Use the following simplified 2009 balance sheet to show.802 Net fixed assets 817 Total assets \$3. in general terms. For example. how an improvement in the DSO would tend to affect the stock price.497 Debt \$1.

Chapter 4: Analysis of Financial Statements Integrated Case 69 .820.035.62. Does it appear that inventories could be adjusted? If so. All of these actions would likely improve the stock price.600/365 = \$19. and reduce debt. Reducing accounts receivable and its DSO will initially show up as an addition to cash. expand the business. the inventory and total assets turnover.180. It appears that the firm either has excessive inventory or some of the inventory is obsolete. I. The freed up cash could be used to repurchase stock.62  32 days = \$616. If inventory were reduced. how should that adjustment affect D’Leon’s profitability and stock price? Answer: The inventory turnover ratio is low.820 = \$261. and reduce the debt ratio even further.Answer: [Show S4-29 through S4-32 here.275.000 – \$616. which should improve the firm’s stock price and profitability. Accounts receivable under new policy = \$19. this would improve the current asset ratio.275.] Sales per day = \$7. Freed cash = old A/R – new A/R = \$878.

As a credit manager. Therefore.J. Terms of COD might be a little harsh and might push the firm into bankruptcy. K. the firm’s current asset ratio is low. what should D’Leon have done back in 2007? Answer: Before the company took on its expansion plans. In hindsight. suppliers could cut the company off. Likewise. sell on terms of COD—but that might cause D’Leon to stop buying from your company. In 2008. continue to sell to D’Leon on credit? (You could demand cash on delivery—that is.) Similarly. also it was not maintaining financial ratios at levels called for in its bank loan agreements. This would lower the firm’s debt ratio and creditors’ risk exposure. as a credit manager. would you recommend renewing the loan or demand its repayment? Would your actions be influenced if in early 2009 D’Leon showed you its 2009 projections along with proof that it was going to raise more than \$1. if the bank demanded repayment this could also force the firm into bankruptcy. would you. it should have done an extensive ratio analysis to determine the 70 Integrated Case Chapter 4: Analysis of Financial Statements . if you were the bank loan officer. and its bank could refuse to renew the loan when it comes due in 90 days.2 million of new equity? Answer: While the firm’s ratios based on the projected data appear to be improving. the company paid its suppliers much later than the due dates. particularly if my firm didn’t have any excess capacity. On the basis of data provided. you would not continue to extend credit to the firm under its current arrangement. Creditors’ actions would definitely be influenced by an infusion of equity capital in the firm.

Difficult to tell whether company is. “Average” performance is not necessarily good. Chapter 4: Analysis of Financial Statements Integrated Case 71 . What are some potential problems and limitations of financial ratio analysis? Answer: [Show S4-33 and S4-34 here. L. Seasonal factors can distort ratios. 5. Sometimes hard to tell if a ratio is “good” or “bad. 3. so a ratio analysis for one firm over time. the company would have “gotten its house in order” before undergoing the expansion. 6.effects of its proposed expansion on the firm’s operations. “Window dressing” techniques can make statements and ratios look better. in a strong or weak position. must be interpreted with judgment. or a comparative analysis of firms of different ages. Different operating and accounting practices distort comparisons. Inflation has badly distorted many firms’ balance sheets.” 4. 8. 2.] Some potential problems are listed below: 1. on balance. Had the ratio analysis been conducted. 7. Comparison with industry averages is difficult if the firm operates many different divisions.

are as follows: 1. What percentage of the company’s business is generated overseas? 5.M. To what extent are the company’s revenues tied to one key product? 3. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? Answer: [Show S4-35 here. To what extent does the company rely on a single supplier? 4. Are changes in laws and regulations likely to have important implications for the firm? 72 Integrated Case Chapter 4: Analysis of Financial Statements . How much competition does the firm face? 6. Are the company’s revenues tied to one key customer? 2. These factors. as summarized by the American Association of Individual Investors (AAII). Is it necessary for the company to continually invest in research and development? 7.] Top analysts recognize that certain qualitative factors must be considered when evaluating a company.