Chapter 5

Analyzing and Interpreting

Financial Statements

Learning Objectives – coverage by question

Mini- Cases
Exercises Problems
Exercises and Projects

LO1 – Prepare and analyze 15, 16,

35
common-size financial statements. 19, 20

LO2 – Compute and interpret

measures of return on investment,
14, 17,
including return on equity (ROE), 25 - 31, 34 36, 38, 41 49
21, 22
return on assets (ROA), and return
on financial leverage (ROFL).

LO3 – Disaggregate ROA into

profitability (profit margin) and 14, 17, 21, 25, 27 - 31, 36, 38,
47 - 49
efficiency (asset turnover) 22, 24 34 41, 45, 46
components.

LO4 – Compute and interpret

measures of liquidity and 18, 23 32, 33 37, 39, 42 49
solvency.

LO5 – Appendix 5A: Measure and

analyze the effect of operating 40, 43
activities on ROE.

LO6 – Appendix 5B: Prepare

35 44
financial statement forecasts.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-1
 QUESTIONS

Q5-1. Return on investment measures profitability in relation to the amount of

investment that has been made in the business. A company can always
increase dollar profit by increasing the amount of investment (assuming it is a
profitable investment). So, dollar profits are not necessarily a meaningful way to
look at financial performance. Using return on investment in our analysis,
whether as investors or business managers, requires us to focus not only on
the income statement, but also on the balance sheet.
Q5-2. ROE is the sum of return on assets (ROA) and the return that results from the
effective use of financial leverage (ROFL). Increasing leverage increases ROE
as long as ROA exceeds the after-tax interest rate. Financial leverage is also
related to risk: the risk of potential bankruptcy and the risk of increased
variability of profits. Companies must, therefore, balance the positive effects of
financial leverage against their potential negative consequences. It is for this
reason that we do not witness companies entirely financed with debt.
Q5-3. Gross profit margins can decline because 1) the industry has become more
competitive, and/or the firm’s products have lost their competitive advantage so
that the company has had to reduce prices or is selling fewer units or 2) product
costs have increased, or 3) the sales mix has changed from higher-
margin/slowly-turning products to lower-margin/higher-turning products.
Declining gross profit margins are usually viewed negatively. On the other
hand, cost increases that reflect broader economic events or certain strategic
product mix changes might not be viewed negatively.
Q5-4. Reducing advertising or R&D expenditures can increase current operating profit
at the expense of the long-term competitive position of the firm. Expenditures
on advertising or R&D are more asset-like and create long-term economic
benefits even though they are not reported as assets on the balance sheet.
Q5-5. Asset turnover measures the amount of revenue volume compared with the
investment in an asset. Generally speaking, we want turnover to be higher
rather than lower. Turnover measures productivity, and an important company
objective is to make assets as productive as possible. Since turnover is one of
the components of ROE (via ROA), increasing turnover increases shareholder
value. Turnover is, therefore, viewed as a value driver.
Q5-6. ROE>ROA implies a positive return on financial leverage. This results from
borrowed funds being invested in operating assets whose return (ROA)
exceeds the cost of borrowing. In this case, borrowing money increases ROE.

©Cambridge Business Publishers, 2020

5-2 Financial Accounting, 6th Edition
Q5-7. Common-size financial statements express balance sheet and income
statement items in ratio form. Common-size balance sheets express each
asset, liability and equity item as a percentage of total assets and common-size
income statements express each line item as a percentage of sales. The ratio
form facilitates comparison among firms of different sizes as well as across
time for the same firm.
Q5-8. The asset turnover ratio (AT) is the ratio of sales revenue to average total
assets. The ratio is increased by increasing sales while holding assets
constant, or by reducing assets without reducing sales. The most effective
means of improving the ratio is to increase the efficient utilization of operating
assets. This is done by improving inventory management practices, improving
accounts receivable collection, and improving the efficient use of PP&E.
Q5-9. The “net” in net operating assets, means operating assets “net” of operating
liabilities. This netting recognizes that a portion of the costs of operating assets
is financed by parties other than the company. For example, payables and
accrued expenses help fund inventories, wages, utilities, and other operating
costs. Similarly, long-term operating liabilities also help finance the cost of long-
term operating assets. Thus, these long-term operating liabilities are deducted
from long-term operating assets.
Q5-10. Companies must manage both the income statement and the balance sheet in
order to maximize ROA. This is important, as many managers look only to the
income statement and do not fully appreciate the value added by effective
balance sheet management. The disaggregation of ROA into its profit margin
and turnover components facilitates analysis of these two areas of focus.
Q5-11. There are an infinite number of possible combinations of margin and turnover
that will yield a given level of ROA. The relative weighting of profit margin and
asset turnover is driven in large part by the company’s business model. As a
result, since companies in an industry tend to adopt similar business models,
industries will generally trend toward points along the margin/turnover
continuum.
Q5-12. Liquidity refers to how much cash a company has, how much cash is coming in,
and how much cash can be raised quickly. Companies must generate cash in
order to pay their debts, pay their employees and provide their shareholders a
return on investment. Cash is, therefore, critical to a company’s survival.
Q5-13. Ratio analysis relies on the data presented in the financial statements and is,
therefore, dependent on the quality of those statements. Differences in the
application of GAAP across companies or within the same company across
time can affect the reliability of the analysis. Limitations of GAAP itself and
differences in the make-up of the company (e.g., types of products or industries
in which the company competes) can also affect the usefulness of ratio
analysis.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-3
 MINI EXERCISES

M5-14. (15 minutes)

LO 2, 3

a. ROE = $5,000/$500,000 = 1%
ROA = $20,000/$1,000,000 = 2%
ROFL = 1% - 2% = -1%

b. Net profit margin = $5,000/$1,000,000 = 0.5%

Asset turnover = $1,000,000/$1,000,000 = 1.0
Financial leverage = $1,000,000/$500,000 = 2.0

c. ROFL is negative for Sunder Company, indicating that financial leverage is hurting
this company. The return on assets is insufficient to cover the interest cost of the
debt. DuPont analysis masks this problem. The financial leverage ratio of 2.0
suggests (incorrectly) that leverage doubled the return.

M5-15. (20 minutes)

LO 1

TARGET CORPORATION
Common-size Balance Sheets
2018 2017
Cash and cash equivalents……………………………………. 6.8% 6.7%
Inventory…………………………………………………………. 22.2% 22.2%
Other current assets……………………………………………. 3.2% 3.1%
Total current assets…………………………………………….. 32.2% 32.0%
Property and equipment, net………………………………….. 64.2% 65.9%
Other noncurrent assets……………………………………….. 3.6% 2.1%
Total assets……………………………………………………… 100.0% 100.0%

Accounts payable………………………………………………. 22.2% 19.4%

Accrued and other current liabilities………………………….. 10.9% 10.0%
Current portion of long-term debt and other borrowings....... 0.7% 4.6%
Total current liabilities…………………………………………. 33.8% 33.9%
Long-term debt and other borrowings……………………….. 29.0% 29.5%
Deferred income taxes…………………………………………. 1.8% 2.3%
Other noncurrent liabilities……………………………………. 5.3% 5.0%
Total shareholders' investment………………………………. 30.0% 29.3%
Total liabilities and shareholders' investment……………….. 100.0% 100.0%

©Cambridge Business Publishers, 2020

5-4 Financial Accounting, 6th Edition
M5-16 (20 minutes)
LO 1

TARGET CORPORATION
Common-size Income Statement
Year ended: February 3, 2018
Sales revenue………………..………………………………………………. 100.0%
Cost of sales…………………………………………………………………. 71.1%
Selling, general and administrative expenses……………………………. 19.8%
Depreciation and amortization……………………………………………… 3.1%
Earnings from continuing operations before interest and income taxes 6.0%
Net interest expense………………………………………………………… 0.9%
Earnings from continuing operations before income taxes……………… 5.1%
Provision for income taxes…………………………………………………. 1.0%
Net earnings from continuing operations ………………………………… 4.1%
Discontinued operations, net of tax ……………………………………….. 0.0%
Net earnings (loss) ………………………………………………………….. 4.1%

M5-17. (15 minutes)

LO 2, 3

($ millions)
a. EWI = $2,928 + $666 x (1 - 0.25) = $3,427.5
(using net earnings from continuing operations)

Average total assets = ($38,999 + $37,431)/2 = $38,215

ROA = $3,427.5/$38,215 = 8.97%

(using net earnings from continuing operations)

Using net earnings, ROA = ($2,934 + (1 - 0.25) × 666)/(($38,999 + $37,431)/2)

= 8.98%

b. Using earnings from continuing operations:

PM = $3,427.5/$71,879 = 4.77%
AT = $71,879 /$38,215= 1.88
4.77% X 1.88 = 8.97%

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-5
M5-18. (20 minutes)
LO 4

a. 2018 Current ratio = $12,564 / $13,201 = 0.95

2017 Current ratio = $11,990 / $12,707 = 0.94

2018 Quick ratio = $2,643 / $13,201 = 0.20

2017 Quick ratio = $2,512 / $12,707 = 0.20

Both of these ratios held steady over the year. Target’s current assets increased
modestly, as did its current liabilities. The make-up of the current liabilities changes
somewhat over the year, with operating liabilities increasing and current debt
repayments decreasing. Both of these ratios are lower than the retail industry
medians, though Target’s scale of operation seems to reassure its creditors.

b. 2018 Times interest earned = $4,312 / $666 = 6.47

2018 Debt-to-equity = ($38,999 - $11,709) / $11,709= 2.33

2017 Debt-to-equity = ($37,431 - $10,953) / $10,953 = 2.42

Target’s debt-to-equity decreased slightly and is lower than the retail industry
median. The times-interest-earned ratio is calculated without including the income
from discontinued operations.

c. Target is liquid and not excessively financially leveraged. Its times interest earned
ratio indicates that earnings before interest and taxes is just about 6.5 times interest
expense. Because the company generates significant operating profits and
operating cash flow ($6.8 billion), we have no solvency concerns about Target.

©Cambridge Business Publishers, 2020

5-6 Financial Accounting, 6th Edition
M5-19. (20 minutes)
LO 1

3M COMPANY
Common-size Balance Sheets
2017 2016
Assets
Current assets
Cash, cash equivalents and marketable securities 10.9% 8.1%
Accounts receivable - net of allowances of $103 and $88 12.9% 13.3%
Total inventories 10.6% 10.3%
Prepaids 2.5% 2.5%
Other current assets 0.7% 1.4%
Total current assets 37.6% 35.6%

Property, plant and equipment - net 23.3% 25.9%

Goodwill 27.7% 27.9%
Intangible assets - net 7.7% 7.1%
Other assets 3.7% 3.6%
Total assets 100.0% 100.0%

Liabilities and Shareholders’ Equity

Current liabilities
Short-term borrowings and current portion of long-term debt 4.9% 3.0%
Accounts payable 5.1% 5.5%
Accrued payroll 2.3% 2.1%
Accrued income taxes 0.8% 0.9%
Other current liabilities 7.1% 7.5%
Total current liabilities 20.2% 18.9%

Long-term debt 31.8% 32.5%

Pension and postretirement benefits 9.5% 12.2%
Other liabilities 7.8% 5.0%
Total liabilities 69.4% 68.6%
Total equity 30.6% 31.4%
Total liabilities and equity 100.0% 100.0%

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-7
M5-20. (15 minutes)
LO 1

3M COMPANY
Common-size Income Statements
2017 2016
Net sales 100.0% 100.0%
Operating expenses
Cost of sales 50.5% 50.0%
Selling, general and administrative expenses 20.8% 20.7%
Research, development and related expenses 5.8% 5.8%
Gain on sale of businesses -1.9% -0.4%
Total operating expenses 75.3% 76.0%
Operating income 24.7% 24.0%
Interest expense 1.0% 0.7%
Interest income -0.2% -0.1%

Income before income taxes 23.8% 23.4%

Provision for income taxes 8.5% 6.6%
Net income including noncontrolling interest 15.4% 16.8%

M5-21. (20 minutes)

LO 2, 3

($ millions)

a. 2017 EWI = $4,869 + $322 x (1 - 0.35) = $5,078.3

2017 Average total assets = ($37,987 + $32,906)/2 = $35,446.5

ROA = $5,078.3/$35,446.5 = 14.33%

b. PM = $5,078.3/$31,657 = 16.04%
AT = $31,657/$35,446.5 = 0.893
16.04% X 0.893 = 14.32% (0.01 difference due to rounding)

©Cambridge Business Publishers, 2020

5-8 Financial Accounting, 6th Edition
M5-22. (15 minutes)
LO 2, 3

($ millions)
a. URBN: Average total assets = ($1,953 + $1,903)/2 = $1,928
ROA = $108 / $1,928 = 5.60%

TJX: Average total assets = ($14,058 + $12,884)/2 = $13,471

ROA = $2,653 / $13,471 = 19.69%

b. URBN: PM = $108 / $3.616 = 2.99%

AT = $3,616 / $1,928 = 1.88
2.99% X 1.88 = 5.62% (0.02 difference due to rounding)

TJX: PM = $2,653 / $35,865 = 7.40%

AT = $35,865 / $13,471 = 2.66
7.40% X 2.66 = 19.68% (0.01 difference due to rounding)

c. URBN’s ROA is quite a bit lower than TJX’s. TJX has a higher PM and AT. As is
typical of value-priced retailers, TJX’s asset turnover is high – its AT is 41% higher
than that of URBN. On balance, TJX’s business model appears to be more
successful in 2017 as it is able to maintain both a high AT and a high PM, resulting
in higher ROA.

M5-23. (20 minutes)

LO 4

($ millions)

a. Verizon’s current ratio for the two years presented is as follows:

2017 current ratio: $29,913 / $33,037 = 0.91

2016 current ratio: $26,395 / $30,340 = 0.87

In 2017, Verizon’s current ratio was below 1.0 which is below the industry median
current ratio of 1.19. We might want to know, however, whether Verizon’s current
assets are concentrated in cash or relatively illiquid inventories, as well as the
maturity schedule of its current liabilities.

Its CR in 2016 is in the same range as 2017. From 2016 to 2017, Verizon reports a
significant increase in accounts receivable and a significant increase in debt due
within the next year.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-9
b. Verizon’s times interest earned ratio for the two years is as follows:

2017 times interest earned = $25,327 / $4,733 = 5.35

2016 times interest earned = $25,362 / $4,376 = 5.80

Verizon’s times interest earned ratio has decreased, but remains higher than the
industry median (2.57).

2017 debt-to-equity = $212,456 / $43,096 = 4.93

2016 debt-to-equity = $220,148 / $22,524 = 9.77

Verizon’s 2016 debt-to-equity ratio is significantly above the 1.83 median for
companies in the telecommunications industry. The ratio decreased dramatically to
4.93 in 2017 due to increased shareholders’ equity.

Verizon’s operating cash flow to current liabilities ratio is as follows:

2017 OCFCL = $25,305 / [($33,037 + $30,340)/2] = 0.80
2016 OCFCL = $22,810 / [($30,340 + $35,052)/2] = 0.70

c. Verizon is carrying a significant amount of debt. Although its profitability and

operating cash flow are fairly strong, neither is particularly high in relation to the
company’s liabilities and interest costs. Verizon’s liquidity appears below that of
others in its industry, and its debt-to-equity is now very high. Given its significant
capital expenditure requirements and its current debt load, Verizon may have to fund
future capital expenditures with higher-cost equity. And, to the extent that its
competitors are not as highly leveraged, this may negatively impact Verizon’s
competitive position.

©Cambridge Business Publishers, 2020

5-10 Financial Accounting, 6th Edition
M5-24. (30 minutes)
LO 3

a.
$ millions Asset Turnover
Procter & Gamble...............................$66,832/$66,119 = 1.01
$184,765/$94,797 =
CVS..................................................... 1.95
Valero Energy.....................................
$88,407/ $48,166 = 1.84

b.
$ millions ART
Procter & Gamble...............................$66,832/$4,640 = 14.40
$184,765/$12,673 =
CVS..................................................... 14.58
Valero Energy.....................................
$88,407/ $6,296 = 14.04

$ millions INVT
Procter & Gamble............................... $33,449/$4,681 = 7.15
$156,208/$15,028 =
CVS..................................................... 10.39
Valero Energy.....................................
$81,926/ $6,047 = 13.55

$ millions PPET
Procter & Gamble...............................$66,832/$20,247 = 3.30
$184,765/$10,234 =
CVS..................................................... 18.05
Valero Energy.....................................
$88,407/ $26,976 = 3.28

c. For all three companies, these ratios reflect differences in their businesses, and the
overall AT ratio is related to the three individual ratios as seen in Exhibit 5.8 in the
chapter. The three companies collect from their customers relative quickly, as seen
in the similar values of ART. Valero carries the smallest amount of inventory relative
to its cost of goods sold. Procter & Gamble’s ratios are influenced by the relative
strength of its largest customer (Walmart), resulting in higher inventory levels and
slower collections. In addition, P&G has a large level of intangible assets, as we will
see in Chapter 8, so its PPET is relatively high, but its AT is the lowest of the three.
CVS’s inventory turnover is higher than P&G. CVS leases most of its store space, so
PP&E is low relative to sales (though that practice will change in the near future as
we will see in Chapter 10).

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-11
 EXERCISES

E5-25. (30 minutes)

LO 2, 3

a.
($ millions)
McDonald’s [$5,192 + $921 x (1 - 0.35)] / $32,414 = 17.9%
Yum! Brands [($1,340 + $440 x (1 - 0.35)] / $5,382 = 30.2%

b.
($ millions) PM = EWI / Sales AT = Sales / Avg. Assets
McDonald’s [$5,192 + $921 x (1 - 0.35)] / $22,820 = $22,820 / $32,414
25.4% = 0.70

Yum! Brands [($1,340 + $440 x (1 - 0.35)] / $5,878 $5,878 / $5,382

= 27.7% = 1.09

c. McDonald’s ROA is lower than Yum! Brands’ in fiscal 2017. The companies’ profit
margins (PM) are similar, but Yum! Brands has a significantly higher asset turnover
(AT). For both firms, asset turnover is influenced by franchising and leasing of retail
stores.

E5-26. (20 minutes)

LO 2

a.
Case A B C D E F
Assets 1,000 1,000 1,000 1,000 1,000 1,000
Non-interest-bearing liabilities 0 0 0 0 200 200
Interest-bearing liabilities 0 250 500 500 0 300
Shareholders’ equity 1,000 750 500 500 800 500

Earnings before interest and taxes 120 120 120 80 100 80

Interest expense 0 25 50 50 0 30
Earnings before taxes 120 95 70 30 100 50
Tax expense (40%) 48 38 28 12 40 20
Net income 72 57 42 18 60 30

ROE 7.2% 7.6% 8.4% 3.6% 7.5% 6.0%

ROA 7.2% 7.2% 7.2% 4.8% 6.0% 4.8%
ROFL 0.0% 0.4% 1.2% -1.2% 1.5% 1.2%

©Cambridge Business Publishers, 2020

5-12 Financial Accounting, 6th Edition
b. These three cases differ only in the amount of interest-bearing liabilities used to
finance the firm. As leverage increases, the return to shareholders’ equity (ROE)
increases. However, the return on assets (ROA) does not change, because the
ROA is independent of the way that the business was financed.

c. However, financial leverage (the use of liabilities to finance the firm) does not always
work in favor of shareholders. The liability holders require a fixed return (6% after-
tax = 10% x (1 – 40%)), and in order for leverage to work in favor of shareholders,
the overall return on assets must exceed this fixed return. In case C, the return on
assets is 7.2% > 6%, so ROFL is positive. In case D, the return on assets is 4.8% <
6%, so ROFL is negative.

In case E, the return on assets equals the after-tax return required on interest-
bearing liabilities, but the company has only non-interest-bearing liabilities. The
ROA is greater than zero, so ROFL is positive. In essence, the rate required on
liabilities is the “break-even” ROA in order for ROFL to be positive.

d. In case F, there is a mixture of liability types. Even though ROA is less than the
amount needed for interest-bearing liabilities, ROFL is positive because some of
Company F’s liabilities require no interest.

The general relationship among these variables is the following:

ROE = ROA + ROA*(NL/SE) + [ROA – (1 – t)*i]*(IL/SE)

where A = Assets,
NL = non-interest-bearing liabilities,
IL = interest-bearing liabilities,
SE = shareholders’ equity,
t = tax rate,
i = pre-tax interest rate on interest-bearing liabilities,
ROE = return on shareholders’ equity, and
ROA = return on assets.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-13
E5-27. (20 minutes)
LO 2, 3

($ millions) CVS Walgreens

a. EWI $6,623 + $1,062 x (1 - 0.35) = $7,313.3 $4,101 + $728 x (1 - 0.35) = $4,574.2

Avg. Assets ($95,131 + $94,462)/2 = $94,796.5 ($66,009 + $72,688) /2 = $69,348.5
ROA $7,313.3/ $94,796.5 = 7.71% $4,574.2/ $69,348.5 = 6.60%

b. PM $7,3313.3/$184,765 = 3.96% $4,574.2/$118,214 = 3.87%

AT $184,765 /$94,796.5 = 1.95 $118,214/$69,348.5 = 1.70

c. Avg. Equity ($37,695 + $36,834)/2 = $37,264.5 ($28,274 + $30,281)/2 = $29,277.5

ROE $6,623 / $37,264.5 = 17.77% $4,101 / $29,277.5 = 14.01%
ROFL 17.77% - 7.71% = 10.06% 14.01% - 6.60% = 7.41%

d. Walgreen’s ROE and ROA are lower than CVS’s. CVS’s PM is slightly higher than
Walgreen’s, but its AT is considerably higher than Walgreen’s. The low PMs for
both companies reflect the highly competitive retail pharmaceutical industry. Both
companies are using financial leverage, but to a larger degree for CVS. Asset
turnover and ROA differences would have to be examined further, because both
companies use operating leases that do not show up on the balance sheet.
(Though, that is scheduled to change in the near future. Chapter 10 looks at this
important topic.)

E5-28. (30 minutes)

LO 2, 3

($ millions)

a. ROE 2017: $9,601 / [($69,019 + $66,226) / 2] = 14.20%

2016: $10,316 / [($66,226 + $61,085) / 2] = 16.21%

b. ROA 2017: [$9,601 + $637x(1 - 0.35)] / [($123,249 + $113,327) / 2] = 8.47%

2016: [$10,316 + $725x(1 - 0.35)] / [($113,327 + $101,459) / 2] = 10.04%

ROFL 2017: 14.20% - 8.47% = 5.73%

2016: 16.21% - 10.04% = 6.17%

ROFL is positive, so leverage is working in favor of Intel’s shareholders.

©Cambridge Business Publishers, 2020

5-14 Financial Accounting, 6th Edition
 c. Net Profit Margin 2017: $9,601 / $62,761 = 15.30%
2016: $10,316 / $59,387 = 17.37%

Asset Turnover 2017: $62,791 / [($123,249 + $113,327) / 2] = 0.531

2016: $59,387 / [($113,327 + $101,459) / 2] = 0.553

Financial 2017: [($123,249 + $113,327) / 2] / [($69,019 + $66,226) / 2] = 1.749

Leverage 2016: [($113,327 + $101,459) / 2] / [($66,226 + $61,085) / 2] = 1.687

Intel’s financial leverage increased slightly from 2016 to 2017. Both ROA and ROE
decreased. Based on ROFL, leverage increased ROE by about 70% over ROA
each year. These increases correspond to the DuPont financial leverage measure
in this case because Intel’s borrowing costs are so low.

In general, there is a bias in DuPont analysis in that it tends to overstate the benefits
of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit
margin, which is lower than PM because the numerator is net of interest costs. For
comparison purposes, Intel’s PM ratios are presented below.

PM ratio 2017: [$9,601 + $637 x (1 - 0.35)] / $62,761 = 15.96%

2016: [$10,316 + $725 x (1 - 0.35)] / $59,387 = 18.16%

E5-29. (30 minutes)

LO 2, 3

($ millions)

a. ROE 2019: €850 / [(€138+€1,477) / 2] = 105.26%

2018: €805 / [(€1,477+€2,184) / 2] = 43.98%
2017: €448 / [(€2,184+$€1,875) / 2] = 22.07%

b. ROA 2019: [€850+€246x(1 - 0.25)] / [(€6,108+€6,451) / 2] = 16.47%

2018: [€805+€208x(1 - 0.25)] / [(€6,451+€7,173) / 2] = 14.11%
2017: [€448+€237x(1 - 0.25)] / [(€7,173+€6,972) / 2] = 8.85%

ROFL 2019: 105.26% - 16.47% = 88.79%

2018: 43.98% - 14.11% = 29.87%
2017: 22.07% - 8.85% = 13.22%

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-15
 c. Net Profit Margin 2019: €850 / €10,364 = 8.20%
2018: €805 / €9,613 = 8.37%
2017: €448 / €8,632 = 5.19%

Asset Turnover 2019: €10,364 / [(€6,108+€6,451) / 2] = 1.650

2018: €9,613 / [(€6,451+€7,173) / 2] = 1.411
2017: €8,632 / [(€7,173+€6,972) / 2] = 1.221

Financial Leverage 2019: [(€6,108+€6,451) / 2] / [(€138+€1,477) / 2] = 7.776

2018: [(€6,451+€7,173) / 2] / [(€1,477+€2,184) / 2] = 3.721
2017: [(€7,173+€6,972) / 2] / [(€2,184+€1,875) / 2] = 3.485

HD Rinker’s ROA increased slightly from 2018 to 2019 (mostly due to better asset
turnover), but its ROE skyrocketed! During both 2018 and 2019, Rinker increased
its liabilities, and significantly reduced its equity. Its debt-to-equity ratio is 43.3 at the
end of fiscal year 2019, so the ROE is greater than 100%. This level of returns is
exceptional for shareholders, but the company’s condition could be precarious if its
performance were to deteriorate.

The DuPont analysis shows that the net profit margin decreased from 2018 to 2019,
but the asset turnover improved significantly. Based on ROFL, leverage increased
ROA by 2.5 times in 2017 (22.07%/8.85%) while in 2019, leverage increased ROA
by a factor of 6.4 (105.26%/16.47%). DuPont analysis suggests that leverage had a
slightly larger impact (3.485 in 2017 and 7.776 in 2019) but the trend is the same.
This is consistent with the bias in DuPont analysis in that it tends to overstate the
effects of financial leverage. Offsetting this bias, DuPont analysis calculates the net
profit margin, which is lower than PM because the numerator is net of interest costs.
For comparison purposes, HD Rinker’s PM ratios are presented below:

PM ratio 2019: [€850+€246x (1-.25)] / €10,364 = 9.98%

2018: [€805+€208x (1-.25)] / €9,613 = 10.00%
2017: [€448+€237x(1-.25)] / €8,632 = 7.25%

©Cambridge Business Publishers, 2020

5-16 Financial Accounting, 6th Edition
E5-30. (20 minutes)
LO 2, 3

($ millions)

a. EWI $181 + $62 x (1 - 0.35) = $221.3

Avg. Equity ($2,120 + $1,852)/2 = $1,986.0
Avg. Assets ($6,323 + $5,540)/2 = $5,931.5
ROE $181 / $1,986.0 = 9.11%
ROA $221.3 / $5,931.5 = 3.73%
ROFL 9.11% - 3.73% = 5.38%

b. PM $221.3 / $10,240 = 2.16%

AT $10,240 / $5,931.5 = 1.73

c. Office Depot has a very low profit margin and an asset turnover that is a little less
than 2.0. This ratio combination is consistent with a low-price, high-volume business
model. However, compared to the retail industry, Office Depot is doing poorly. Both
its AT and its PM are below the median. As a result, its ROA and ROE are well
below the industry medians.

E5-31. (20 minutes)

LO 2, 3

($ millions)

a. EWI $1,211 + $20 x (1-.35) = $1,224.0

Avg. Equity ($2,354 + $1,354) / 2 = $1,854.0
Avg. Assets ($5,178 + $4,068) / 2 = $4,623.0
ROE $1,211 / $1,854.0 = 65.32%
ROA $1,224.0 / $4,623.0 = 26.48%
ROFL 65.32% - 26.48% = 38.84%

b. PM $1,224.0 / $5,964 = 20.52%

AT $5,964 / $4,623.0 = 1.29

c. Intuit has a relatively high PM ratio and a low AT ratio. These numbers are
consistent with the business model employed in the software industry. Contrast
these numbers with those of Office Depot (E5-30). Intuit uses financial leverage
effectively; leverage increased its ROA by a factor of almost 2.5 (65.32%/26.48%).

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-17
E5-32. (30 minutes)
LO 4

a.
2017 2016
Current ratio $6,570,520/$7,674,670 = 0.86 $6,259,796/$5,827,005 = 1.07

($3,367,914+$155,323+$515,381) ($3,393,216+$105,519+$499,142)/$5,827,005
Quick ratio
/$7,674,670 = 0.53 = 0.69

b.
2017 2016
Debt-to-
$23,022,980/$5,632,392 = 4.09 $16,750,167/$5,913,909 = 2.83
equity ratio

Times-
(-2,209,032 + $471,259)/$471,259
interest-
= -3.69
earned ratio

c. Cash burn rate = (-60,654 - $3,414,814)/365 days = -$9,522 thousand per day.

Tesla’s financial condition has been a topic of considerable discussion in the recent
past. Its current and quick ratios have dropped from 2016 to 2017, and they are
among the lowest in Exhibit 5.13. (The restricted cash should not be considered an
available resource for paying obligations, but the amount is not very significant.)
The same is true of its debt-to-equity ratio. The times-interest-earned ratio doesn’t
tell us much because it’s negative. Tesla is not earning income from which interest
cash be paid; rather it is earning losses that are increased by interest expense. As
of 2017, Tesla is using up cash for operations and capital expenditures at the rate of
about $10 million per day. With $3.3 billion in cash as of the end of 2017, that
means that if Tesla continues to spend at the same rate, it will run out of cash in late
2018.

But that’s a very big “if,” and it is the source of disagreement among investors.
Almost every new company starts its life with negative free cash flow. But every
successful new company must reach a point where it stops consuming cash and
begins to generate cash. The 2018 quarterly reports for Tesla appear to show that
point may have been reached.

©Cambridge Business Publishers, 2020

5-18 Financial Accounting, 6th Edition
E5-33. (30 minutes)
LO 4

a. ($ millions) Current Ratio OCFCL

2015 €51,442 / €39,562 = 1.30 €6,612 / [(€36,598 + €39,562) / 2] = 0.174

2016 €55,329 / €42,916 = 1.29 €7,611 / [(€39,562 + €42,916) / 2] = 0.185

2017 €58,429 / €43,394 = 1.35 €7,176 / [(€42,916 + €43,394) / 2] = 0.166

Siemens has a current ratio that is above 1.0 and has been steady around 1.3 over
these years. Moreover, its OCFCL ratio stayed in the same range around 0.175.
While the current ratio provides a useful point estimate of liquidity, the OCFCL ratio
suggests that operations are not generating sufficient net cash flow to cover short-
term obligations, but it would be useful to also get a sense of the volume of resource
flows relative to the current liabilities. Siemens’ revenues for 2017 exceeded €83
billion.

b. ($ millions) Times interest earned Debt-to-equity

2015 €(7,218 + 818) / €818 = 9.82 €85,293 / €34,474 = 2.47

2016 €(7,404 + 989) / €989 = 8.49 €90,901 / €34,211 = 2.66

2017 €(8,306 + 1,051) / €1,051 = 8.90 €89,277 / €43,089 = 2.07

The times interest earned ratio decreased in 2016 but rebounded in 2017. Siemens’
debt-to-equity ratio has been quite high around 2.50, but decreased in 2017.

c. It’s always a good idea to look into the numbers that make up the ratios before
coming to conclusions. For instance, Siemens’ current liabilities include about €10.3
billion in unearned revenue, representing more than a quarter of its current liabilities.
In the normal course of business, deferred performance liabilities like these aren’t
paid off with cash – rather Siemens must provide the agreed-upon services and
products to the customers.

It’s not easy to place Siemens into one of the industry groups in Exhibit 5.13, but its
DE ratio appears to be higher than any industry median except utilities. However, its
TIE appears to be in a satisfactory range. And, the company’s size and diversified
businesses give it a stability that can reassure lenders.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-19
E5-34. (30 minutes)
LO 2, 3

($ millions)

a. EWI $848 + $74 x (1 - 0.35) = $896.1

Avg. Equity ($3,144 + $2,904) / 2 = $3,024.0
Avg. Assets ($7,989 + $7,610) / 2 = $7,799.5
ROE $848 / $3,024.0 = 28.04%
ROA $896.10 / $7,799.5 = 11.49%
ROFL 28.04% - 11.49% = 16.55%

b. PM $896.10 / $15,855 = 5.65%

AT $15,855 / $7,799.5 = 2.033

c. GPM $6,066 / $15,855 = 38.26%

INVT $9,789 / [($1,997 + $1,830) / 2] = 5.116

d. The Gap showed strong performance in the year ended February 3, 2018 (hereafter,
2017), with modest improvements over 2016. Its ROA was 11.5%, which is high for
the retail industry. ROE was almost 30% indicating the effective use of financial
leverage. Interest costs were low, suggesting that most of The Gap’s debt is from
operating liabilities (accounts payable and accrued expenses). Its profit margin and
asset turnover ratios place The Gap in a strong position for this industry.

The GPM and INVT ratios are two important performance measures for retail
companies such as The Gap. GPM measures the ability of the firm to sell its
merchandise at reasonable margins while INVT provides evidence on inventory
management and the popularity of its product line. Both measures are near the
median for retailers in 2017.

©Cambridge Business Publishers, 2020

5-20 Financial Accounting, 6th Edition
E5-35.B (20 minutes)
LO 1, 6

a. & b.

THE GAP, INC.

Common-size and Income Statement Forecasts

Net sales 100.0% 100.0% $15,800 $16,300 $16,800

Cost of goods sold and occupancy
expenses 63.7% 61.7% 9,796 10,106 10,416
Gross profit 36.3% 38.3% 6,004 6,194 6,384
Operating expenses 28.7% 28.9% 4,582 4,727 4,872
Operating income 7.7% 9.3% 1,422 1,467 1,512
Interest expense 0.5% 0.5% 74 74 74
Interest income -0.1% -0.1% (19) (19) (19)
Income before income taxes 7.2% 9.0% 1,367 1,412 1,457
Income taxes 2.9% 3.6% 342 353 364
Net income 4.4% 5.3% $ 1,025 $ 1,059 $ 1,093

c. Note: 2016 and 2017 common size statements are reversed (2016 on the left).
Forecasted statements are presented for three different sales levels. The Gap’s
statement forecasts are based on (1) projected sales and (2) a set of assumptions
that determine the relationship between various expense items and sales revenue.
The accuracy of the projection depends on the reliability of these estimates, which
depends on management’s ability to maintain a stable GPM ratio, maintain INVT
ratio, and control operating expense ETS ratios. It also depends on which costs are
variable and which are fixed. If SG&A expenses were fixed at the 2017 level
regardless of 2018 sales, then the forecasted statements would show a greater
variation in profits as sales change.

©Cambridge Business Publishers, 2020

Solutions Manual, Chapter 5 5-21