Chapter 14: Financial Ratios and Firm Performance

Chapter
14
Financial Ratios and Firm Performance
LEARNING OBJECTIVES (Slide 14-‐2)
1. Create, understand, and interpret common-size financial statements.
2. Calculate and interpret financial ratios.
3. Compare different company performances using financial ratios, historical financial
ratio trends, and industry ratios.
IN A NUTSHELL…
Financial statements can provide vital information for managers and analysts, if they
know how to organize the “mess” of numerical data into a meaningful format which can
be used to analyze, and interpret the performance of firms. In this chapter, the author
explains how accounting information can be re-cast into common size financial
statements and various ratios, which can then be used in conjunction with industry
benchmarks, to diagnose the strengths and weaknesses of companies and conduct
comparisons among companies.
LECTURE OUTLINE
14.1 Financial Statements (Slides 14-‐3 to 14-‐9)
Just like a doctor takes a look at a patient’s x-rays or cat-scan when diagnosing health
problems, a manager or analyst can take a look at a firm’s primary financial statements
i.e. the income statement and the balance sheet, when trying to gauge the status or
performance of a firm.
As explained in earlier chapters, the income statement provides a periodic recording of
the sources of revenue and expenses of a firm, while the balance sheet provides a point in
time snap shot of the firm’s assets, liabilities and owner’s equity.
14.1 (A) Benchmarking: The financial statements by themselves constitute fairly
complex documents involving a whole bunch of numbers.
The values are absolute in nature, and although they tell us something about the amount
of assets, liabilities, equity, revenues, expenses, and taxes of a firm, unless they are
“benchmarked” against some standard, it is difficult to really gauge what’s going on,
primarily because of size and maturity differences among firms.
One common method of benchmarking a is to compare a firm’s current performance
against that of its own performance over a 3-5 year period (trend analysis), by looking at
the growth rate in various key items such as sales, costs, and profits as shown in Table
14.1 below.
470
©2013 Pearson Education, Inc. Publishing as Prentice Hall
Chapter 14 n Financial Ratios and Firm Performance 471
Another useful way to make some sense out of this mess of numbers, is to re-cast the
income statement and the balance sheet into common size statements, by expressing each
income statement item as a percent of sales and each balance sheet item as a percent of
total assets as shown in Figures 14.3 and 14.4 (shown below)

472 Brooks n Financial Management: Core Concepts, 2e
Benchmarking is a good starting point to detect trends (if any) in a firm’s performance
and to make quick comparisons of key financial statement values with competitors on a
relative basis.
More in-depth diagnosis requires individual item analyses and comparisons which are
best done by conducting ratio analysis.
14.2 Financial Ratios (Slides 14-‐10 to 14-‐25)

Financial ratios are relationships between different accounts from financial statements—
usually the income statement and the balance sheet—that serve as performance indicators
Being relative values, financial ratios allow for meaningful comparisons across time,
between competitors, and with industry averages.
This section covers 5 key areas of a firm’s performance which can be analyzed using
financial ratios:
1. Liquidity ratios: Can the company meet its obligations over the short term?
2. Solvency ratios: (also known as financial leverage ratios): Can the company meet its
obligations over the long term?
3. Asset management ratios: How efficiently is the company managing its assets to
generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the company’s financial
prospects?
It also discusses Du Pont analysis which involves a breakdown of the return on equity
into its three components, i.e. profit margin, turnover, and leverage.

14.2 (A) Short-‐Term Solvency: Liquidity Ratios: measure a company’s ability to cover
its short-term debt obligations in a timely manner:
Three key liquidity ratios include: The current ratio, quick ratio, and cash ratio as shown
below:
Table14.2 summarizes the 3 liquidity ratios of Cogswell Cola and Spacely Spritzers.
It seems like overall, Cogswell has better liquidity and short-term solvency than Spacely,
but, higher investment in current assets also means that lower yields are being realized
since current assets are typically low yielding.
So, we need to look at the other areas and inter-related effects of the firm’s various
accounting items.
14.2 (B) Long-‐Term Solvency: Financial Leverage Ratios: measure a company’s ability
to meet its long-term debt obligations based on its overall debt level and earnings
capacity.
Failure to meet its interest obligation could put a firm into bankruptcy.
Equations 14.4, 14.5, and 14.6 can be used to calculate 3 key financial leverage ratios: the
debt ratio, times interest earned ratio, and cash coverage ratio.

Table 14.3 indicates that in the area of financial leverage, Cogswell Cola is in a much
better position than Spacely Spritzers, since it has relatively less debt and a significantly
greater ability to cover its interest obligations by using either its EBIT (times interest
earned ratio) or its net cash flow (cash coverage ratio).
Leverage must be analyzed as a combination of debt level and coverage. If a firm is
heavily leveraged but has good interest coverage, it is using the interest deductibility
feature of taxes to its benefit. Having a high leverage with low coverage could put the
firm into a risk of bankruptcy.
14.2 (C) Asset Management Ratios: measure how efficiently a firm is using its assets to
generate revenues or how much cash is being tied up in other assets such as receivables
and inventory.
Equations 14.7 – 14.11 can be used to calculate 5 key asset management ratios.
Table 14.4, which lists the 5 asset management ratios for the 2 firms, shows that while
Cogswell is more efficient in managing its inventory, Spacely seems to be doing a better
job of collecting its receivables and utilizing its total assets in generating revenues.

14.2 (D) Profitability Ratios: such as net profit margin, returns on assets, and return on
equity, measure a firm’s effectiveness in turning sales or assets into profits.
Table 14.5 indicates that as far as profitability is concerned, Cogswell is outperforming

Spacely by about 3%.
14.2 (E) Market Value Ratios: as computed in Equations 14.15-14.18, are used to gauge
how attractive or reasonable a firm’s current price is relative to its earnings, growth rate,
and book value.
Potential investors and analysts often use these ratios as part of their valuation analysis.
Typically, if a firm has a high price to earnings and a high market to book value ratio, it
is an indication that investors have a good perception about the firm’s performance.
However, if these ratios are very high it could also mean that a firm is over-valued.
With the price/earnings to growth ratio (PEG ratio), the lower it is, the more of a bargain
it seems to be trading at, vis-à-vis its growth expectation.
Ratio Cogswell Cola Spacely Spritzers
P/E 15.41 13.01
PEG 1.28 0.86
P/B 5.49 4.17
The ratios seem to indicate that investors in both firms seem to have good expectations
about their performance and are therefore paying fairly high prices relative to their
earnings book values.

14.2 (F) DuPont analysis: involves breaking down ROE into three components of the
firm:
1. operating efficiency, as measured by the profit margin (net income/sales);
2. asset management efficiency, as measured by asset turnover (sales/total assets); and
3. financial leverage, as measured by the equity multiplier (total assets/total equity).
Equation 14.19 shows that if we multiply a firm’s net profit margin by its total asset
turnover ratio and its equity multiplier, we will get its return on equity.
The calculations indicate that Cogswell has better operational efficiency, i.e. it is better
able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets,
and since it uses more debt, it is able to get more of its earnings to its shareholders.
Although these 14 ratios are not the only ones that can be used to assess a firm’s
performance, they are the most popular ones.
It is important to look at the overall picture of the firm in all 5 areas and accordingly
reach conclusions or make recommendations for changes.
14.3 External Uses of Financial

Statements and Industry Averages (Slides 14-‐26 to 14-‐29)
Financial statements of publicly traded companies and industry averages of key items
provide the raw material for analysts and investors to make investment recommendations
and decisions.
14.3 (A) Cola Wars: Table 14.6 and 14.7 provide financial information about two key
competitors in the soft-drink industry, Coca-Cola and Pepsico.

One of the first things we notice in looking over the five years of data is how similar
many of the ratios are from year to year, showing remarkable consistency for these two
companies.
We also can see that the gross margin of Coca-Cola is consistently higher than that of
PepsiCo.
The debt to equity ratio of both firms is mostly falling over the five-year period.

We also can see that ROE has been very good for both companies, although slightly
better for PepsiCo.
Finally, PepsiCo has very strong and growing earnings per share over this period,
outperforming Coca-Cola’s EPS, but PepsiCo is also more expensive (higher current
price per share).
Although these ratios don’t clearly point out to a winner, they do help the analyst in
getting a better picture about each firm’s performance.
Financial ratio analysis remains more of an art than a science!
Industry ratios: such as the ones shown in Table 14.8, are often used as benchmarks for
financial ratio analysis of individual firms.
There can be significant differences in various key areas across industries, which is why
comparing company ratios with industry averages can be very useful and more
informative.
Questions
1. What is the accounting identity?
Assets ≡ Liabilities + Owner’s Equity
2. What does analyzing companies over time tell a finance manager?
Trend analysis tells a financial manager the rate at which the various key items are
growing and helps explain why profits are growing or eroding over time.
3. What does restating financial statements into common-size financial statements
allow a finance manager or financial analyst to do?
Common-size financial statements allow a comparison of companies that are very
different in size. It then allows comparison of management choices, such as debt
financing or analysis of production costs.
4. What are liquidity ratios? Given an example of a liquidity ratio and how it helps
evaluate a company’s performance or future performance from an outsider’s
view.

Liquidity ratios are ratios that show the short-term cash obligation capabilities of the
company. The current ratio is a liquidity ratio and it is current assets divided by
current liabilities. When this ratio is greater than one it indicates a company should
have sufficient cash from its current assets to pay off its current liabilities. This helps
an outsider evaluate potential cash flow problems of the company.
5. What are solvency ratios? Which ratio would be of most interest to a banker
considering a debt loan to a company? Why?
Solvency ratios are ratios that demonstrate the ability of the company to meet debt
obligations over an extended period of time. A banker would probably be most
interested in Times Interest Earned to see if the company has sufficient cash from
operations to handle more interest payments on a new loan.
6. What are asset management ratios? For retail firms, what is one of the key
management ratios? Why?
Asset management ratios are ratios that indicate how well the management team is
using the assets of the company to generate profits. For retail firms inventory turnover
is a key ratio because it tells management how quickly the firm is moving their
product from the shelf to the customer.
7. What does the P/E ratio tell an outsider about a company? Why might this ratio
not provide very compelling evidence on the firm's performance?
The P/E ratio is telling an outsider the number of years it will take to recover the
current price of the stock if the earnings remain constant. Some analysts will say the
P/E ratio tells you if the firm is a growth firm or a stable firm with growth firms
having higher P/E ratios. The ratio is not very compelling because it uses historical
earnings with current price and because price is a function of future earnings it should
really use the future earnings of the firm against price.
8. What are the three components of the DuPont identity? What do they analyze?
The three components of the DuPont analysis are, (1) operating efficiency, (2) asset
management efficiency, and (3) financial leverage. They analyze the return on equity
or the shareholders’ return.
9. What does analyzing companies against their industry tell a finance manager or
financial analyst?
Analyzing companies against their industry will tell the finance manager what
direction the company is headed and if there are potential trouble areas ahead for the
company if it stays on the same course. Analyzing companies against the industry
tells analysts if the company is competitively strong or weak relative to the other
players.
10. What does analyzing a company against firms in other industries tell a financial
manager or analyst?
Analyzing a company against firms in other industries may indicate what areas the
company and its industry are falling behind in general. It can also highlight the
fundamental differences of the industry that make it more difficult or easier to
produce profits, borrow from debt markets, or develop new products.

Prepping for Exams

1. c
2. c
3. a
4. t
5. b
6. a
7. a
8. d
9. c
10. a
Problems
1. Income statement. Fill in the missing numbers on the following annual income
statements for Barron Pizza Inc.
ANSWER
Year Ending 2011 Year Ending 2010 Year Ending 2009

Revenue $917,378 $946,219 $971, 232
COGS $747,937 $669,382 $656,215
Gross Profit $169,441 $276,837 $315,017
SG&A $70,505 $153,702 $193,000
Research & Dev. $5,469 $7,129 $3,521
Depreciation $32,927 $34,579 $35,713
Operating Income $60,540 $81,427 $82,783
Other Income $672 $1,126 $1,958
EBIT $61,212 $82,553 $84,741
Interest Expense $6,851 $7,677 $8,857
Income Before Tax $54,361 $74,876 $75,884
Taxes $20,385 $28,079 $28,639
Net Income $33,976 $46,797 $47,245
Shares Outstanding 16,740,000 16,740,000 16,740,000
EPS $2.03 $2.78 $2.82

2. Income statement. Construct the Barron Pizza Inc. income statement for the year
ending 2011 with the following information:
Shares outstanding: 16,740,000
Tax rate: 37.5%
Interest expense: $6,114
Revenue: $889,416
Depreciation: $31,354
Selling, general, and administrative expense: $77,572
Other income: $1,253
Research and development: $4,196
Cost of goods sold: $750,711
ANSWER
Income Statement
Barron Pizza Incorporated
Year Ending 2011
Revenue $889,416
COGS $750,711
Gross Profit $138,705
Operating Expenses
SG&A $ 77,572
Research & Development $ 4,196
Depreciation $ 31,354
Operating Income $ 25,583
Other Income $ 1,253
EBIT $ 26,836
Interest Expense $ 6,114
Taxable Income $ 20,722
Taxes $ 7,771
Net Income $ 12,951
Shares Outstanding 16,740,000
EPS $0.77
3. Balance sheet. Fill in the missing information on the annual Balance Sheets
Statements for Barron Pizza Inc.

ANSWER
All $ in Thousands
At Dec. 31, At Dec. 31, At Dec. 31,
2011 2010 2009
ASSETS
Cash $7,071 $9,499 $17,609
Accts. Receivables $26,767 $20,638 $25,877
Inventory $17,030 $16,341 $12,659
Other Current $11,590 $10,955 $8,986
Total Current $62,458 $57,433 $65,131
Long Term Invest. $19,102 $21,864 $20,998
Net PP&E $203,818 $223,599 $238,945
Goodwill $48,577 $48,756 $48,274
Other Assets $13,259 $13,817 $14,091
TOTAL ASSETS $347,214 $365,469 $387,439
LIABILITIES
Accounts Payable $80,667 $74,467 $66,209
Short Term Debt $250 $235 $225
Current Liab. $80,917 $74,702 $66,434
Long Term Debt $61,000 $139,850 $185,085
Other Liab. $46,025 $28,970 $20,288
TOTAL LIAB. $187,942 $243,522 $271,807
Owner’s Equity
Common Stock $119,901 $102,421 $102,107
Retained Earnings $39,371 $19,526 $13,525
Total OE $159,272 $121,947 $15,632
TOTAL LIAB & $347,214 $365,469 $387,439

OE

4. Balance sheet. Construct the Barron Pizza Inc. balance sheet statement for
December 31, 2011, with the following information:
Retained earnings: $43,743
Accounts payable: $74,633
Accounts receivable: $34,836
Common stock: $119,901
Cash: $8,344
Short-term debt: $210
Inventory: $23,455
Goodwill: $48,347
Long-term debt: $80,207
Other noncurrent liabilities: $42,580
Plant, property, and equipment: $192,465
Other noncurrent assets: $16,838
Long-term investments: $22,331
Other current assets: $14,658
ANSWER
Barron Pizza Incorporated
Balance Sheet at 12/31/2011
Assets: Liabilities:
Current Assets Current Liabilities
Cash $ 8,344 Accounts Payable
$ 74,633
Accts. Rec. $ 34,836 Short Term Debt $ 210
Inventory $ 23,455 TOTAL Current Liab. $ 74,843
Other Current $ 14,658 Long Term Debt $ 80,207
Total Current $ 81,293 Other Liabilities $ 42,580
L- T Inv. $ 22,331 Total Liabilities $197,630
PP&E $ 192,465 Owner’s Equity
Goodwill $ 48,347 Common Stock $119,901
Other Assets $ 16,838 Retained Earnings $ 43,743
Total Assets $361,274 Total OE $163,644
Total Liab. And OE $361,274
5. Predicting net income. Below is an abbreviated income statement for Wal-Mart.

Predict the net income for the period ending January 31, 2010, by determining the
growth rates of sales, COGS, SG&A, and interest expense. Use a tax rate of 37%.

ANSWER
Growth rates; Sales = (405,607 / 348,650)1/2 – 1 = 0.0786 or 7.86%
COGS = (306,158 / 264,152)1/2 -1 = 0.0766 or 7.66%
SG&A = (76,367 / 63,721)1/2 -1 = 0.0947 or 9.47%
Interest = (2,184 / 1,809)1/2 -1 = 0.0988 or 9.88%
2010 Predictions
Sales = $405,607 × 1.0786 = $437,485
COGS = $306,158 × 1.0766 = $329,603
SG&A = $76,367 × 1.0947 = $83,602
Interest = $2,184 × 1.0988 = $2,400
EBIT = $437,485 – $329,603 – $83,602 = $24,280
Taxes = ($24,280 – $2,400) × 0.37 = $8,096
Wal-Mart, Inc. Abbreviated Income Statements for the Year Ending
(In Millions of Dollars)
Account Jan. 31, 2007 Jan.31, 2008 Jan. 31, Jan. 31, 2010
2009
Sales $348,650 $378,799 $405,607 $437,485
COGS $264,152 $286,515 $306,158 $329,603
SG&A $63,721 $69,983 $76,367 $83,602
EBIT $20,777 $22,301 $23,082 $24,280
Interest $1,809 $2,103 $2,184 $2,400
Taxes $7,684 $7,468 $7,498 $8,096
Net Income $11,284 $12,731 $13,400 $13,784

6. Predicting net income. Below is an abbreviated income statement for Starbucks.

Predict the net income for the period ending September 30, 2009, by determining the
growth rates of sales, COGS, depreciation, and SG&A. Use a tax rate of 37%. Then
look up the numbers for Starbucks for 2009 and see how you did.
ANSWER
Growth rates; Sales = (10,383 / 7,786)1/2 – 1 = 0.1548 or 15.48%
COGS = (4,654 / 3,179)1/2 -1 = 0.2100 or 21.00%
SG&A = (5,216 / 3,701)1/2 -1 = 0.1872 or 18.72%
What to do about forecasting interest? Until you have more information it is probably
best to just use 2008 for 2009.
2009 Predictions
Sales = $10,383 × 1.1548 = $11,990
COGS = $4,654 × 1.2100 = $5,631
SG&A = $5,216 × 1.1872 = $6,192
EBIT = $11,990 – $5,631 – $6,192 = $167
Interest = $53
Taxes = ($167 – $53) × 0.37 = $42
Starbucks Abbreviated Income Statements for the Year Ending
(In Millions of Dollars)
Account Sep. 30, 2006 Sep. 30, 2007 Sep. 30, 2008 Sep. 30, 2009
Sales $7,786 $9,411 $10,383 $11,990
COGS $3,179 $3,999 $4,654 $5,631
SG&A $3,701 $4,356 $5,216 $6,192
EBIT $906 $1,056 $513 $167
Interest $0 $0 $53 $53

Account Sep. 30, 2006 Sep. 30, 2007 Sep. 30, 2008 Sep. 30, 2009
Taxes $342 $384 $145 $42
Net Income $564 $672 $315 $72
7. Common-size financial statements. Prepare common-size income statements for

Wal-Mart and Starbucks using the January 2009 and September 2008 information
provided in Problems 5 and 6.Which company is doing a better job of getting sales
dollars to net income? Where is the one company having an advantage over the other
company in turning revenue into net income?
ANSWER
Wal-Mart Starbucks
Account Jan. 31, 2009 Percent Sep. 30, 2008 Percent
Sales $405,607 100.00% $10,383 100%
COGS $306,158 75.48% $4,654 44.82%
SG&A $76,367 18.83% $5,216 50.24%
EBIT $23,082 5.69% $513 4.94%
Interest $2,184 0.54% $53 0.51%
Taxes $7,498 1.85% $145 1.40%
Net Income $13,400 3.30% $315 3.03%
Both Wal-Mart and Starbucks bring a little over 3 cents of sales revenue to the bottom
line. Starbuck’s has an advantage over Wal-Mart in the cost of goods sold but Wal-Mart
has a much smaller selling, general and administrative expense. Why these companies
enjoy these different advantages is a question that will take more financial and economic
investigation into the operations of the two companies and the industries in which they
operate.
8. Common-size financial statements. Below is the balance sheet information on two

companies. Prepare a common-size balance sheet for each company. Review each
company's percentage of total assets. Are these companies operating with similar
philosophies or in similar industries? What appears to be the major difference in
financing for these two companies?

Account B. Sheet Co. 1 % of Total B. Sheet Co. 2 % of Total

Assets Assets
Current Assets
Cash $5,377 11.14% $299 8.98%

Investments $4,146 8.59% $354 10.64%

Accts. Rec. $8,100 16.78% $221 6.64%
Inventory $5,372 11.13% $494 14.84%
Total Current $22,995 47.65% $1,368 41.11%
Long Inv. $84 0.17% $307 9.22%
PP&E $9,846 20.40% $1,471 44.20%
Goodwill $5,390 11.17% $69 2.07%
Intangible $6,149 12.74% $27 0.81%
Other $3,799 7.87% $86 2.58%
Total Assets $48,263 100.00% $3,328 100.00%
Liabilities
Accts. Pay. $12,309 25.50% $661 19.86%
Short –Term D $1,139 2.36% $0 0.00%
Other Short Lia $0 0.00% $122 3.67%
Current. Liab. $13,448 27.86% $783 23.53%
Long-Term D $2,955 6.12% $4 0.12%
Other Liab. $4,991 10.34% $54 1.62%
Total Liab. $21,394 44.32% $841 25.27%
Owner’s Equity
Common Stock $3,120 6.46% $1,026 30.83%
Treasury Stock ($6,754) -13.39% $0 0.00%
Retained Earn. $30,503 63.20% $1,461 43.90%
Total Equity $26,869 55.67% $2,487 74.73%
Total Liab. &

Owner’s Equity $48,263 100.00% $3,328 100.00%
While students may find many differences that characterize the different philosophies of
these two companies, one major difference is the use of debt financing by company one
and the lack of debt financing for company two. Company two has been using equity
financing and internally generated cash flow for financing (it is Starbucks). Company one
also has much higher intangible assets such as patents and registration rights (it is
Johnson and Johnson).

For Problems 9 through 12, use the following data:
9. Financial ratios: Liquidity. Calculate the current ratio, quick ratio, and cash ratio for
Tyler Toys for 2010 and 2011. Should any of these ratios or the change in a ratio
warrant concern for the managers of Tyler Toys or the shareholders?
ANSWER
Current Ratio = Current Assets / Current Liabilities
2011 is, $1,630,300 / $1,857,200 = 0.8778
2010 is, $1,504,700 / $1,787,700 = 0.8417

Quick Ratio (or Acid Ratio Test) = Current Assets – Inventories / Current
Liabilities
2011 is, ($1,630,300 – $587,500) / $1,857,200 = 0.5615
2010 is, ($1,504,700 – $563,600) / $1,787,700 = 0.5264
Cash Ratio = Cash / Current Liabilities
2011 is, $191,100 / $1,857,200 = 0.1029
2010 is, $188,900 / $1,787,700 = 0.1057
The ratios look reasonable and the change is in the right direction for better liquidity for
all ratios except the cash ratio.
10. Financial ratios: Financial leverage. Calculate the debt ratio, times interest earned
ratio, and cash coverage ratio for 2010 and 2011 for Tyler Toys. Should any of these
ratios or the change in a ratio warrant concern for the managers of Tyler Toys or the
shareholders?
ANSWER
Solvency Ratios
Debt Ratio = (Total Assets – Total Equity) / Total
Assets or Total Liabilities / Total
Assets
2011 is, ($14,689,500 – $2,711,700) / $14,689,500 = 0.8154
2010 is, ($14,119,500 – $3,052,300) / $14,119,500 = 0.7838
Times interest Earned = EBIT / Interest Expense
2010 is, $3,199,300 / $375,000 = 8.5315
2009 is, $2,979,700 / $356,100 = 8.3676
Cash Coverage = EBIT + Depreciation / Interest Expense
2011 is, ($3,199,300 + $1,498,900) / $375,000 = 12.5285
2010 is, ($2,979,700 + $1,473,240) / $356,100 = 12.5047
The debt ratio is very high and would warrant concern if the cash coverage ratio or the
times interest earned ratio was low but with high ratios this means they are handling their
large debt well.
11. Financial ratios: Asset management. Calculate the inventory turnover, days’ sales in
inventory, receivables turnover, days’ sales in receivables, and total asset turnover
ratios for 2010 and 2011 for Tyler Toys. Should any of these ratios or the change in a
ratio warrant concern for the managers of Tyler Toys or the shareholders?
ANSWER
Asset Management Ratios
Inventory Turnover = Cost of Goods Sold / Inventory
2011 is, $8,449,100 / $587,500 = 14.3814
2010 is, $8,131,300 / $563,600 = 14.4274

Day’s Sales in Inventory = 365 / Inventory Turnover

2011 is, 365/14.3814 = 25.3799 Days
2010 is, 365/14.4274 = 25.2990 Days
Receivables Turnover = Sales / Accounts Receivable
2011 is, $14,146,700 / $669,400 = 21.1334
2010 is, $13,566,400 / $630,400 = 21.5203
Day’s Sales in Receivables = 365/ Receivables Turnover
2011 is, 365 / 21.1334 = 17.2712 Days
2010 is, 365 / 21.5203 = 16.9607 Days
Total Asset Turnover = Sales / Total Assets
2011 is, $14,146,700 / $14,689,500 = 0.9630
2010 is, $13,566,400 / $14,119,500 = 0.9608
The company has a very good turnover of assets and collects its receivables quickly thus
there are no real concerns from these ratios.
12. Financial ratios: Profitability. Calculate the profit margin, return on assets, and
return on equity for 2010 and 2011 for Tyler Toys. Should any of these ratios or the
change in a ratio warrant concern for the managers of Tyler Toys or the shareholders?
ANSWER
Profitability Ratios
Profit Margin = Net Income / Sales
2011 is, $2,075,900 / $14,146,700 = 0.1467
2010 is, $1,933,800 / $13,566,400 = 0.1425
Return on Assets = Net Income / Total Assets
2011 is, $2,075,900 / $14,689,500 = 0.1413
2010 is, $1,933,800 / $14,119,500 = 0.1370
Return on Equity = Net Income / Total Owner’s Equity
2011 is, $2,075,900 / $2,711,700 = 0.7655
2010 is, $1,933,800 / $3,052,300 = 0.6336
These ratios indicate a very strong firm performance for the equity holders with an ROE
of over 75% for 2011.
13. DuPont identity. For the following firms, find the return on equity using the three
components of the DuPont identity: operating efficiency, as measured by the profit
margin (net income/sales); asset management efficiency, as measured by asset
turnover (sales/total assets); and financial leverage, as measured by the equity
multiplier (total assets/total equity).

ANSWER
First find the equity of each company i.e. Total Assets less Total Liabilities:
Pepsi’s Equity = $35,994 – $23,888 = $12,106
Coca-Cola’s Equity = $40,519 – $20,047 = $20,472
Starbuck’s Equity = $5,673 – $3,182 = $2,491
Next calculate the three components
Company Operating Efficiency Asset Mgmt. Efficiency Financial Leverage
Pepsi $5,142/$43,251= $43,251/$35,994= 1.2016 $35,994 / $12,106 =
0.1189 2.9732
Coca-Cola $5,807 / $31,994 = $31,994 / $40,519 = $40,519 / $20,472 =
0.1815 0.7896 1.9792
Starbucks $315 / $10,383 = $10,383 / $5,673 = $5,673 / $2,491 =
0.0303 1.8302 2.2774
Last, take the three components to find the ROE,
Pepsi = 0.1189 × 1.2016 × 2.9732 = 0.4247 or 42.47% ROE
Coca-Cola = 0.1815 × 0.7896 × 1.9792 = 0.2837 or 23.87% ROE
Starbuck’s = 0.03034 × 1.8302 × 2.2774 = 0.1265 or 12.65% ROE
While Coca-Cola is the most operationally efficient and Starbucks is the most efficient in
management, Pepsi is the best to its shareholders because it has effectively utilized a very
high financial leverage strategy, using debt and not shareholder earnings to finance the
profits of the firm.
14. DuPont identity. Go to a Web site such as Yahoo.com and find the sales, net income,
total assets, and total equity of the following five actively traded companies:
Microsoft (MSFT), Boeing (BA),Wal-Mart (WMT), Procter and Gamble (PG), and
Waste Management (WMI). Use the three components of the DuPont identity—
operating efficiency, as measured by the profit margin (net income/sales); asset
management efficiency, as measured by asset turnover (sales/total assets); and
financial leverage, as measured by the equity multiplier (total assets/total equity)—to
find the return on equity for these five companies. Based on these components and
the ROE, which company do you think is doing the best job for its shareholders?
ANSWER (Note: the dates for the data for each firm are shown in the table below)
$ ‘000s MSFT BA WMT PG WM

06/30/2011 12/31/2010 01/31/2011 06/30/2011 12/31/2010

Net Income 23,150 3,307 16,389 11,797 953
Sales 69,943 64,306 421,849 82,599 12,515
T. Assets 108,704 68,565 180,663 138,354 21,476
Sh. Equity 57,083 2,766 68,542 68,001 6,260
Net Profit
Margin 0.331 0.051 0.039 0.143 0.076
Total Asset
T/O 0.643 0.938 2.335 0.597 0.583
Equity
Multiplier 1.904 24.789 2.636 2.035 3.431
ROE 40.6% 119.6% 23.9% 17.3% 15.2%
Microsoft is the most operationally efficient; Wal-Mart is the most efficient in asset
management. However, Bank of America has an unusually high equity multiplier, which
is quite typical of a bank, and thus it has the highest ROE.
15. Company analysis. Go to a Web site such as Yahoo.com and find the financial
statements of Disney (DIS) and McDonald’s (MCD). Compare these two companies
using the following financial ratios: times interest earned, current ratio, asset
turnover, financial leverage, profit margin, PEG ratio, and return on equity. Which
company would you invest in, either as a bond holder or a stockholder?
ANSWER
Look up these values for each company (2011 year-end figures used here),
Sales, EBIT, Interest Expense, Net Income, Current Assets, Total Assets, Current
Liabilities, Equity, PE ratio, EPS 5-year expected growth rate
Disney McDonalds
Sales 40,893 24,074.60
EBIT 8,043 7,451.2
Interest Expense 0 450.9
Net Income 4,807 4,946.3
Current Assets 13,757 4,368.5
Total Assets 72,124 31,975.2
Current Liabilities 12,088 2,924.7

Equity 37,385 14,634.20

PE ratio 15 15.8
5-year EPS expected growth 12% 9%
rate

Disney is, $8,043 / $0 = Undefined (since Disney had no interest expenses)
McDonalds is, $7451.2 / $450.9 = 16.53
Disney is, $13,757 / $12,088 = 1.138
McDonalds is, $3,517.6 / $2,537.9 = 1.3860
Asset Turnover = Sales / Total Assets
Disney is, $40, 893/ $72,124 = 0.567
McDonalds is, $24, 074.6 / $31,975.2 = 0.75
Financial Leverage = Total Assets / Total Equity
Disney is, $72, 124 / $37, 385 = 1.929
McDonalds is, $31, 975 / $14, 634.2 = 2.18
Disney is, $4,807 / $40, 893 = 0.1180
McDonalds is, $4,946.3 / $24,074.6 = 0.21
PEG ratio = Current PE ratio/Expected EPS growth rate
Disney’s PEG = 15/12 = 1.25; McDonald’s PEG = 15.8/9 =1.76
Disney is, $4,807 / $37,385 = 0.1286
McDonalds is, $4,946.3 / $14 634.2 = 0.338
The best company to invest in appears to be McDonalds with its higher ROE and strong
solvency position as most of the financial ratios are very similar across these firms.
16. Company analysis. Go to a Web site such as Yahoo.com and find the financial
statements of General Motors (GM) and Ford Motor Company (F). Compare these
two companies using the following financial ratios: times interest earned, current
ratio, asset turnover, financial leverage, profit margin, PEG ratio, and return on
equity. Which company would you invest in, either as a bond holder or a stockholder?
ANSWER
Look up these values for each company; Sales, EBIT, Interest Expense, Net Income,
Current Assets, Total Assets, Current Liabilities, and Equity(2010 year-end figures used
here)
‘000s General Motors Ford Motor Company

Sales $135,592 $128,974

EBIT $6,639 $7,149
Interest Expense $1,098 $0
Net Income $6, 172 $6,561
Current Assets $53,053 $48,875
Total Assets $138,898 $164,687
Current Liabilities $102,718 $60,206
Equity $36,180 -$673
General Motors is$6,639 / $1,098 = 6.05X
Ford Motor Company is, $7,149 / $0 = Undefined
General Motors is, $53,053 / $102,718 = 0.52
Ford Motor Company is, $48,875 / $60,206 = 0.81
Asset Turnover = Sales / Total Assets
Ford Motor Company is, $128,974 / $164,687 = 0.78
Financial Leverage = Total Assets / Total Equity
Ford Motor Company is, $164,687 / $-673 = -244
PEG ratio = PE ratio/Expected EPS growth rate
General Motors = 1.82 (from key statistics)
Ford Motor Company = 0 .83
General Motors is, $6,172 / $135,592 = 4.5%
Ford Motor Company is $6,562 / $128,974 =5.1%
General Motors is, $6,172 / $36,180 = 17.06%
Ford Motor Company, $6,562 / -$673 = -975.04%
Ford Motor Company had a slightly better profit margin, no interest on debt, and was
selling at a fairly low PEG ratio. Although General Motors had a better turnover ratio, its
low liquidity and fairly high leverage makes it a risky bet.

Solutions for Advanced Problems for Spreadsheet Application

1. DuPont analysis.
Oil Companies
DuPont Analysis
Company Data 2009 2008 2007
Exxon Mobil
Revenue $ 310,586,000 $ 477,359,000 $ 404,552,000
Net Income $ 19,280,000 $ 45,220,000 $ 40,610,000
Total Assets $ 55,235,000 $ 72,266,000 $ 85,963,000
Total Equity $ 110,569,000 $ 112,965,000 $ 121,762,000
Chevron
Revenue $ 171,636,000 $ 273,005,000 $ 220,904,000
Net Income $ 10,483,000 $ 23,931,000 $ 18,608,000
Total Assets $ 164,621,000 $ 161,165,000 $ 148,786,000
Total Equity $ 91,914,000 $ 86,648,000 $ 77,088,000
Conoco Phillips
Revenue $ 68,025,000 $ 246,182,000 $ 194,495,000
Net Income $ 7,011,000 $ (16,988,000) $ 11,891,000
Total Assets $ 79,019,000 $ 142,865,000 $ 177,757,000
Total Equity $ 55,991,000 $ 55,165,000 $ 88,983,000
Marathon Oil
Revenue $ 54,139,000 $ 78,569,000 $ 65,207,000
Net Income $ 1,463,000 $ 3,528,000 $ 3,956,000
Total Assets $ 47,052,000 $ 42,686,000 $ 42,746,000
Total Equity $ 21,910,000 $ 21,409,000 $ 19,223,000
Occidental Petroleum
Revenue $ 15,403,000 $ 24,480,000 $ 20,013,000
Net Income $ 2,915,000 $ 6,857,000 $ 5,400,000
Total Assets $ 44,229,000 $ 41,537,000 $ 36,519,000
Total Equity $ 29,081,000 $ 27,300,000 $ 22,823,000

Table Of Ratios
2009
Company Operating Efficiency Asset Mgmt Efficency
Financial Leverage Return on Equity
Exxon Mobil
2009 6.21% 5.6230 0.4996 17.44%
2008 9.47% 6.6056 0.6397 40.03%
2007 10.04% 4.7061 0.7060 33.35%
Average 8.57% 5.6449 0.6151 29.77%
Chevron
2009 6.11% 1.0426 1.7910 11.41%
2008 8.77% 1.6939 1.8600 27.62%
2007 8.42% 1.4847 1.9301 24.14%
Average 7.77% 1.4071 1.8604 20.33%
Conoco Phillips
2009 10.31% 0.8609 1.4113 12.52%
2008 -6.90% 1.7232 2.5898 -30.79%
2007 6.11% 1.0942 1.9977 13.36%
Average 3.17% 1.2261 1.9996 7.78%
Marathon Oil
2009 2.70% 1.1506 2.1475 6.68%
2008 4.49% 1.8406 1.9938 16.48%
2007 6.07% 1.5255 2.2237 20.58%
Average 4.42% 1.5056 2.1217 14.12%
Occidental Petroleum
2009 18.92% 0.3483 1.5209 10.02%
2008 28.01% 0.5894 1.5215 25.12%
2007 26.98% 0.5480 1.6001 23.66%
Average 24.64% 0.4952 1.5475 18.88%
Industry
2009 8.85% 1.8051 1.4741 11.61%
2008 8.77% 2.4905 1.7210 15.69%
2007 11.52% 1.8717 1.6915 23.02%
Average 9.71% 2.0558 1.6288 16.77%

50.00%
40.00%
30.00%
20.00% ExxonMobil
Chevron
10.00%
Conoco Phillips
0.00%
Marathon
2009 2008 2007
-‐10.00% Occidental
-‐20.00%
-‐30.00%
-‐40.00%
2. Common-size statements: Proctor & Gamble and Johnson & Johnson and their
ratios.
Income Statements Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi
2009 2009 2008 2008 2007 2007
Total Revenue $ 30,990,000 $ 43,232,000 $ 31,944,000 $ 43,251,000 $ 28,857,000 $ 39,474,000
Operating Expenses $ 11,088,000 $ 20,099,000 $ 11,374,000 $ 20,351,000 $ 10,406,000 $ 18,038,000
Gross Margin $ 19,902,000 $ 23,133,000 $ 20,570,000 $ 22,900,000 $ 18,451,000 $ 21,436,000
Operating Expenses
SG&A $ 11,671,000 $ 15,026,000 $ 11,744,000 $ 15,901,000 $ 11,199,000 $ 14,208,000
Non Recurring $ 350,000
Other $ 63,000 $ 64,000 $ 58,000
Inc. From Cont. Ops $ 8,231,000 $ 8,044,000 $ 8,476,000 $ 6,935,000 $ 7,252,000 $ 7,170,000
Other Inc./Exp. (Net) $ 289,000 $ 67,000 $ 305,000 $ 41,000 $ 1,077,000 $ 685,000
EBIT $ 8,520,000 $ 8,111,000 $ 8,781,000 $ 6,976,000 $ 8,329,000 $ 7,855,000
Interest Expense $ 355,000 $ 397,000 $ 438,000 $ 329,000 $ 456,000 $ 224,000
Income Before Taxes $ 8,165,000 $ 7,714,000 $ 8,343,000 $ 6,647,000 $ 7,873,000 $ 7,631,000
Income Taxes $ 2,040,000 $ 2,100,000 $ 1,632,000 $ 1,879,000 $ 1,892,000 $ 1,973,000
Net Income $ 6,125,000 $ 5,614,000 $ 6,711,000 $ 4,768,000 $ 5,981,000 $ 5,658,000

Income Statements Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi

Common Common Common Common Common Common
Size 09 Size 09 Size 08 Size 08 Size 07 Size 07
Total Revenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Operating Expenses 35.78% 46.49% 35.61% 47.05% 36.06% 45.70%
Gross Margin 64.22% 53.51% 64.39% 52.95% 63.94% 54.30%
Operating Expenses
SG&A 37.66% 34.76% 36.76% 36.76% 38.81% 35.99%
Non Recurring 1.10%
Other 0.15% 0.15% 0.15%
Inc. From Cont. Ops 26.56% 18.61% 26.53% 16.03% 25.13% 18.16%
Other Inc./Exp. (Net) 0.93% 0.15% 0.95% 0.09% 3.73% 1.74%
EBIT 27.49% 18.76% 27.49% 16.13% 28.86% 19.90%
Interest Expense 1.15% 0.92% 1.37% 0.76% 1.58% 0.57%
Income Before Taxes 26.35% 17.84% 26.12% 15.37% 27.28% 19.33%
Income Taxes 6.58% 4.86% 5.11% 4.34% 6.56% 5.00%
Net Income 19.76% 12.99% 21.01% 11.02% 20.73% 14.33%
Balance Sheets
Assets
Current Assets
Cash and Equivalents $ 6,959,000 $ 3,943,000 $ 4,701,000 $ 2,064,000 $ 4,093,000 $ 910,000
Short Term Investments $ 2,192,000 $ 192,000 $ 278,000 $ 213,000 $ 215,000 $ 1,571,000
Net Receivables $ 3,758,000 $ 4,624,000 $ 3,090,000 $ 4,683,000 $ 3,317,000 $ 4,389,000
Inventories $ 2,354,000 $ 2,618,000 $ 2,187,000 $ 2,522,000 $ 2,220,000 $ 2,290,000
Other Current Assets $ 2,288,000 $ 1,194,000 $ 1,920,000 $ 1,324,000 $ 2,260,000 $ 991,000
TOTAL Current Assets $ 17,551,000 $ 12,571,000 $ 12,176,000 $ 10,806,000 $ 12,105,000 $ 10,151,000
Long-term Investments $ 6,755,000 $ 4,484,000 $ 5,779,000 $ 3,998,000 $ 7,777,000 $ 4,475,000
Plant, Prop. & Equip. (NET) $ 9,561,000 $ 12,671,000 $ 8,326,000 $ 11,663,000 $ 8,493,000 $ 11,228,000
Goodwill $ 4,224,000 $ 6,534,000 $ 4,029,000 $ 5,124,000 $ 4,256,000 $ 5,169,000
Intangible Assets $ 8,604,000 $ 2,623,000 $ 8,476,000 $ 1,860,000 $ 7,963,000 $ 2,044,000
Accumulated Amortization
Other Assets $ 1,976,000 $ 965,000 $ 1,733,000 $ 2,324,000 $ 2,675,000 $ 1,356,000
Deferred Long-term assets $ 219,000 $ 205,000
TOTAL ASSETS $ 48,671,000 $ 39,848,000 $ 40,519,000 $ 35,994,000 $ 43,269,000 $ 34,628,000

Balance Sheets Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi

Assets Size 09 Size 09 Size 08 Size 08 Size 07 Size 07
Current Assets
Cash and Equivalents 14.30% 9.90% 11.60% 5.73% 9.46% 2.63%
Short Term Investments 4.50% 0.48% 0.69% 0.59% 0.50% 4.54%
Net Receivables 7.72% 11.60% 7.63% 13.01% 7.67% 12.67%
Inventories 4.84% 6.57% 5.40% 7.01% 5.13% 6.61%
Other Current Assets 4.70% 3.00% 4.74% 3.68% 5.22% 2.86%
TOTAL Current Assets 36.06% 31.55% 30.05% 30.02% 27.98% 29.31%
Long-term Investments 13.88% 11.25% 14.26% 11.11% 17.97% 12.92%
Plant, Prop. & Equip. (NET) 19.64% 31.80% 20.55% 32.40% 19.63% 32.42%
Goodwill 8.68% 16.40% 9.94% 14.24% 9.84% 14.93%
Intangible Assets 17.68% 6.58% 20.92% 5.17% 18.40% 5.90%
Accumulated Amortization
Other Assets 4.06% 2.42% 4.28% 6.46% 6.18% 3.92%
Deferred Long-term assets 0.00% 0.61% 0.59%
TOTAL ASSETS 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi
Current Liabilities 2009 2009 2008 2008 2007 2007
Accounts Payable $ 6,921,000 $ 8,292,000 $ 6,152,000 $ 6,494,000 $ 7,173,000 $ 6,209,000
Short/Current Debt $ 6,800,000 $ 464,000 $ 6,531,000 $ 369,000 $ 6,052,000
Other Current Liab. $ - $ 305,000 $ 1,924,000 $ - $ 1,544,000
Total Current Liab. $ 13,721,000 $ 8,756,000 $ 12,988,000 $ 8,787,000 $ 13,225,000 $ 7,753,000
Long-Term Debt $ 5,059,000 $ 7,400,000 $ 2,781,000 $ 7,858,000 $ 3,277,000 $ 4,203,000
Other Liabilities $ 2,965,000 $ 5,591,000 $ 3,401,000 $ 7,017,000 $ 3,133,000 $ 4,792,000
Deferred Long-Term Debt $ 1,580,000 $ 659,000 $ 877,000 $ 226,000 $ 1,890,000 $ 646,000
Minority Interests $ 547,000 $ 638,000
TOTAL LIABILITIES $ 23,872,000 $ 23,044,000 $ 20,047,000 $ 23,888,000 $ 21,525,000 $ 17,394,000
Stockholder's Equity
Misc. Options $ (104,000)
Redemmable PS $ (97,000)
Preferred Stock $ 41,000
Common Stock $ 880,000 $ 30,000 $ 880,000 $ 30,000 $ 880,000 $ 30,000
Retained Earnings $ 41,537,000 $ 33,805,000 $ 38,513,000 $ 30,638,000 $ 36,235,000 $ 28,184,000
Treasury Stock $ (25,398,000) $ (13,383,000) $ (24,213,000) $ (14,122,000) $ (23,375,000) $ (10,519,000)
Capital Surplus $ 8,537,000 $ 250,000 $ 7,966,000 $ 351,000 $ 7,378,000 $ 450,000
Other Stock. Equity $ (757,000) $ (3,794,000) $ (2,674,000) $ (4,694,000) $ 626,000 $ (952,000)
TOTAL STOCKHOLDER'S EQU. $ 24,799,000 $ 16,804,000 $ 20,472,000 $ 12,106,000 $ 21,744,000 $ 17,234,000
TOTAL LIAB. & ST. EQUITY$ 48,671,000 $ 39,848,000 $ 40,519,000 $ 35,994,000 $ 43,269,000 $ 34,628,000

Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Coca-Cola

Current Liabilities Size 09 Size 09 Size 08 Size 08 Size 07 Size 07
Accounts Payable 14.22% 20.81% 15.18% 18.04% 16.58% 17.93%
Short/Current Debt 13.97% 1.16% 16.12% 1.03% 13.99%
Other Current Liab. 0.75% 5.35% 4.46%
Total Current Liab. 28.19% 21.97% 32.05% 24.41% 30.56% 22.39%
Long-Term Debt 10.39% 18.57% 6.86% 21.83% 7.57% 12.14%
Other Liabilities 6.09% 14.03% 8.39% 19.49% 7.24% 13.84%
Deferred Long-Term Debt 3.25% 1.65% 2.16% 0.63% 4.37% 1.87%
Minority Interests 1.12% 1.60%
TOTAL LIABILITIES 49.05% 57.83% 49.48% 66.37% 49.75% 50.23%
Stockholder's Equity
Misc. Options -0.26%
Redemmable PS -0.27%
Preferred Stock 0.12%
Common Stock 1.81% 0.08% 2.17% 0.08% 2.03% 0.09%
Retained Earnings 85.34% 84.83% 95.05% 85.12% 83.74% 81.39%
Treasury Stock -52.18% -33.59% -59.76% -39.23% -54.02% -30.38%
Capital Surplus 17.54% 0.63% 19.66% 0.98% 17.05% 1.30%
Other Stock. Equity -1.56% -9.52% -6.60% -13.04% 1.45% -2.75%
TOTAL STOCKHOLDER'S EQU. 50.95% 42.17% 50.52% 33.63% 50.25% 49.77%
TOTAL LIAB. & ST. EQUITY100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Ratio or Account 2009 2008 2007

Gross Margin Pepsi 53.51% 52.95% 64.39%
Gross Margin Coke 64.22% 64.39% 53.51%
Inventory Turnover Pepsi 7.68 8.07 7.88

Inventory Turnover Coke 5.20 7.40 4.69
Current Ratio Pepsi 1.44 1.23 1.31

Current Ratio Coke 1.28 0.94 0.92
Return on Assets Pepsi 14.09% 13.25% 16.34%

Return on Assets Coke 12.58% 16.56% 13.82%
Return on Equity Pepsi 33.41% 39.39% 32.83%

Return on Equity Coke 24.70% 32.78% 27.51%
Debt to Equity Pepsi 1.37 1.97 1.01

Debt to Equity Coke 0.96 0.98 0.99
Earnings Per Share Pepsi $ 3.49 $ 2.96 $ 3.51

Earnings Per Share Coke $ 2.65 $ 2.91 $ 2.59

Solutions to Mini-‐Case

Cranston Dispensers, Inc.: Part 2
This case requires students to prepare and interpret a Statement of Cash Flows or Sources
and Uses, Common Size Statements, and Financial Ratios for a straightforward
manufacturing firm which is based on a composite of firms in the dispenser and container
industries. Students will use the DuPont identity to isolate areas of strength and
weakness. Finally, students are asked to deduce, based on what they can observe in the
statements, what internal variances may have occurred.
1. Cranston’s Common Size Income Statements and Balance Sheets for 2009 and
2008 are given below. Prepare common size statements for 2010.
Common size statements
Income statements 2010 2009 2008
Sales 100.00% 100.00% 100.00%

Cost of goods sold 67.86% 67.83% 67.25%
Gross profit 32.14% 32.17% 32.75%
Selling & adm. expenses 14.53% 14.93% 14.71%
Depreciation 6.53% 7.18% 7.25%
EBIT 11.07% 10.06% 10.80%
Interest expense (net of interest income) 0.54% 0.77% 0.52%
Earnings Before Taxes 10.53% 9.28% 10.28%
Taxes 3.16% 2.79% 3.08%
Net Income 7.37% 6.50% 7.20%
Assets
Balance sheets 2010 2009 2008
Assets
Cash 9.80% 8.84% 9.38%
Accounts receivable 20.75% 20.57% 12.72%
Inventory 17.10% 16.40% 15.42%
Current assets 47.64% 45.82% 37.52%
Net fixed assets 52.36% 54.18% 62.48%
Total assets 100.00% 100.00% 100.00%

Liabilities and Equity

Accounts payable 9.54% 9.23% 8.11%
Accrued Expenses 9.86% 10.73% 7.63%
Short-term Debt 14.45% 15.73% 9.66%
Current liabilities 33.85% 35.69% 25.40%
Long term debt 11.44% 10.38% 11.49%
Other liabilities 6.87% 4.93% 5.84%
Total liabilities 52.16% 51.01% 42.73%
Common equity 21.98% 20.15% 21.50%
Total stockholders' equity 47.84% 48.99% 57.27%
Total liab. & equities 100.00% 100.00% 100.00%
2. Complete the 2010 table of financial ratios for Cranston.

The 2010 financial ratios are computed as follows.
Liquidity
$1658
Current Ratio = = 1.41
$1178
Quick Ratio (or Acid Ratio Test) =

($1658 − $595) = .90
$1178
$341
Cash Ratio = = .29
$1178
Solvency
$1815
Debt Ratio = = .52
$3480
$419
Times Interest Earned = = 20.44
$20.50
($419 + $247)
Cash Coverage Ratio = = 32.49
I$20.50
Asset Management
$2568
Inventory Turnover = = 4.32
$595
365
Day' s Sale in Inventory = = 84.57
4.32

$3784
Receivables Turnover = = 5.24
$722
365
Day's Sale in Receivables = = 69.64
5.24
$3784
Total Asset Turnover = = 1.09
$3480
Profitability
$278.95
Profit Margin = = 7.37%
$3784
$278.95
Return on Assets (ROA) = = 8.02%
$3480
$278.95
Return on Equity (ROE) = = 16.75%
$1665
Market
$278.95
Earnings Per Share (EPS) = = $1.95
143
$33
Price Earnings Ratio (P/E) = = 16.92
$1.95
⎛ $3784 ⎞
Earnings Growth Rate = ⎜ ⎟ − 1 = 34%
⎝ $3202 ⎠
16.92
PEG =
34 =.50
$1665
Book Value per Share = = $11.64
143
$33
Market to Book = = 2.83
$11.64
3. Use the common size statements and the ratio analysis you have completed above
to comment on Cranston’s:
a. Liquidity
Cranston Industry
Liquidity
2010 2009 2008 2010
Current ratio 1.41 1.28 1.48 2.10
Quick ratio 0.90 0.82 0.87 1.10

Cash ratio 0.29 0.25 0.37 .39

Cranston’s liquidity ratios are all below the industry average and either stable or
declining. Low liquidity ratios can indicate either an aggressive pursuit of
efficiency where the company attempts to achieve results with a minimum
investment in current assets or it may indicated higher than average current
liabilities. The asset management ratios suggest a somewhat inefficient use of
current assets, so the latter explanation is more likely.
b. Solvency
Total Debt Ratio 0.52 0.51 0.43 0.25
Times Interest Earned 20.44 13.04 20.84 19.00
Cash Coverage 32.49 22.35 34.83 35.
The total debt ratio indicates a slightly higher than average use of debt financing
and the rising trend suggests increasing reliance on debt financing. On the other
hand, the 2009 Times Interest Earned ratio is above average, suggesting that
Cranston can easily handle its interest payments. The Cash Coverage ratio is
below the industry average, but still high. It indicates that Cranston has $32.49 of
EBITDA for every dollar of interest expense, so risk of financial distress is low.
c. Asset management
Inventory Turnover 4.32 4.24 4.78 5.20
Days' sales in inventory 84.57 86.04 76.30 70.19
Receivables turnover 5.24 4.99 8.63 6.81
Days sales in receivables 69.64 73.18 42.32 53.60
Total asset turnover 1.09 1.03 1.10 1.80
Inventory turnover and receivables turnover are both lower than the industry
average, indicating that Cranston is using its current assets inefficiently. The days
sales in inventory and receivables merely convert turnovers into days and are just
a different way of looking at the same information. Total asset turnover is stable,
but well below the industry average, most likely because of the inefficiencies
noted in the use of current assets.
d. Profitability
Profit Margin 7.37% 6.50% 7.20% 8.60%
Return on total assets 8.02% 6.67% 7.89% 15.48%
Return on equity 16.75% 13.61% 13.78% 20.59%
Cranston’s profitability measures are stable, and even improving slightly, but
remain below the industry averages. The increase in Return on Equity is largely
due to an increasing Total Debt ratio.
e. Market performance
Earnings Per Share (EPS) $1.95 $1.46 $1.39 not meaningful

Price/Earnings (P/E) 16.92 26.11 23.04 21.00

Earnings Growth Rate 34% 5% 17.5% 18%
PEG 0.50 5.45 1.32 1.17
Book value $11.64 $10.69 $10.08 not meaningful
Market/Book 2.83 3.55 3.18 4.26
Cranston’s market performance shows that the market measures results against
expectations. Even though earnings grew at a rate of 34% in 2009, investors
apparently do not believe that this rate is sustainable. Averaged over the 3 years,
Cranston’s growth rate in earnings is just about average for the industry. The
Price/Earnings, PEG, and Market to Book ratios are all below the industry
averages suggesting that investors are no longer optimistic about Cranston’s
future. These averages also indicate, however, that Cranston stock may be
attractively priced.
4. Express Cranston’s Return on Equity (ROE) in terms of the DuPont identity.
Which ratios are contributing to Cranston’s below average ROE?
By substituting ratios for raw numbers, we can express the Dupont Identity as Profit
Margin × Total Asset Turnover × Total Assets/Total Equity = Return on Equity. For
the industry average, we get 8.60% × 1.80 × (1/(1-.25) =20.59% and for Cranston
7.37% × 1.09 x(1/(1-.52) = 16.75%. The DuPont equation clearly shows that
Cranston’s below average Return on Assets is caused first by an inefficient use of
assets and second by below average profit margins. Cranston makes up for, or
perhaps masks, these shortcomings by using more debt than the average company in
its industry.
5. Based on your analyses in questions 1 through 4, why do you think Cranston’s
recent stock performance has been disappointing?
Many firms experiencing rapid growth in sales and earnings tend to focus on
marketing and expanding production while becoming careless about efficiency and
financial management. When sales growth slows to more normal levels, these
inefficiencies can no longer be ignored and the firm must deal with them. Cranston
has allowed inventories to exceed the industry average, is slower than average in
collecting its bills, and seems to have some excess capacity in fixed assets. Investors
also consider a great deal of information that may not be available simply by
analyzing financial statements, but the statements do reveal a company that seems to
be maturing in terms of growth and must now find other ways to maintain the value
of its stock.
Additional Problems with Solutions

1. Constructing an Income Statement. Using the income and expense account
information for Tri-Mark Products Inc. listed below, construct an income statement
for the year ended 31st December, 2011.
Shares outstanding: 16,740,000

Tax rate: 35%

Interest expense: $3,540,000
Revenue: $950,500,000
Depreciation: $50,000,000
Selling, general, and administrative expense: $85,000,000
Other income: $1,350,000
Research and development: $5,200,000
Cost of goods sold: $730,000,000
ANSWER (Slides 14-‐30 to 14-‐31)
Tri-mark Products Incorporated

Income Statement for the year ended 31st Dec. 2011 ('000s)
Revenue $ 950,500
Cost of goods sold $ 730,000
Gross Profit $ 220,500
Operating expenses
Selling, general and administrative expenses $ 85,000
R&D $ 5,200
Depreciation $ 50,000
Operating Income $ 80,300
Other Income $ 1,350
EBIT $ 81,650
Interest Expense $ 3,540
Taxable Income $ 78,110
Taxes $ 27,339
Net Income $ 50,772
Shares Outstanding (‘000s) 16,740
EPS $ 3.03
2. Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s 2011 year-end

Balance Sheet using the asset, liability, and equity accounts listed below:
Retained Earnings $60,500,000
Accounts Payable $57,000,000
Accounts Receivable $43,000,000
Common Stock $189,676,000

Cash $6,336,000
Short Term Debt $1,500,000
Inventory $42,000,000
Goodwill $30,000,000
Long Term Debt $74,000,000
Other Non-Current Liabilities $15,000,000
PP&E $225,000,000
Other Non-Current Assets $14,000,000
Long-Term Investments $25,340,000
Other Current Assets $12,000,000
Tri-mark Products Inc.

Balance Sheet as at year ended
31st December 2011 (‘000s)
Assets: Liabilities:
Cash $6,336 Accounts Payable $57,000
Accts. Rec. $43,000 Short Term Debt $1,500
Inventory $42,000 TOTAL Current Liabilities. $58,500
Other Current $12,000 Long Term Debt $74,000
Total Current $103,336 Other Liabilities $15,000
L- T Inv. $25,340 Total Liabilities $147,500
PP&E $225,000 Owner’s Equity
Goodwill $30,000 Common Stock $189,676
Other Assets $14,000 Retained Earnings $60,500
Total Assets $397,676 Total OE $250,176
Total Liab. And OE $397,676
3. Common size statements. Re-state Tri-Mark Incorporated’s 2011 financial statements

as common-size statements and comment on them

Trimark Product Inc’s Common Size Balance Sheet as at 31st December 2011

% of
% of Total Total
Assets: Assets Liabilities: Assets
Cash $6,336 0.02 Accounts Payable $57,000 0.14
Accts. Rec. $43,000 0.11 Short Term Debt $1,500 0.00
Inventory $42,000 0.11 TOTAL Current Liab. $58,500 0.15
Other Current $12,000 0.03 Long Term Debt $74,000 0.19
Total Current $103,336 0.26 Other Liabilities $15,000 0.04
L- T Inv. $25,340 0.06 Total Liabilities $147,500 0.37
PP&E $225,000 0.57 Owner’s Equity
Goodwill $30,000 0.08 Common Stock $189,676 0.48
Other Assets $14,000 0.04 Retained Earnings $60,500 0.15
Total Assets $397,676 1.00 Total OE $250,176 0.63
Total Liab. And OE $397,676 1.00
Tri-Mark’s debt position seems to be moderate with less than 40% debt relative to total
assets. Their total current assets are about double their total current liabilities. We would
need to compare these figures with either an industry benchmark or with a competitor’s
ratios to get a better feel for their overall asset and liability positions.
Tri-mark Products Incorporated

Common Size Income Statement for the year ended
31st Dec. 2011 ('000s)
Revenue $ 950,500 100.0%
Cost of goods sold $ 730,000 76.8%
Gross Profit $ 220,500 23.2%
Operating expenses
Selling, general and administrative
expenses $ 85,000 8.9%
R&D $ 5,200 0.5%
Depreciation $ 50,000 5.3%
Operating Income $ 80,300 8.4%
Other Income $ 1,350 0.1%
EBIT $ 81,650 8.6%
Interest Expense $ 3,540 0.4%

Taxable Income $ 78,110 8.2%

Taxes $ 27,339 2.9%
Net Income $ 50,772 5.3%
Shares Outstanding (‘000s) 16,740
EPS $ 3.03
Trimark’s cost of goods sold is 76.8% of its revenue. Its gross margin is 23.2%, while its
net profit margin is 5.3%. It would be useful to compare these key cost and profit ratios
over time and against a suitable benchmark so as to get a better idea of the firm’s overall
performance.
4. Compute and analyze financial ratios. Using the 2011 income statement and balance
sheet of Trimark Products Inc., as constructed in problems 1 and 2 above, compute its
financial ratios. How is the firm doing relative to its industry in the areas of liquidity,
asset management, leverage, and profitability?
Industry
Ratio Average
Current Ratio 2.200
Quick Ratio (or Acid Test Ratio) 1.500
Cash Ratio 0.135
Debt Ratio 0.430
Cash Coverage 10.600
Day’s Sales in Receivables 29.000
Total Asset Turnover 2.800
Inventory Turnover 20.100
Day’s Sales in Inventory 11.500
Receivables Turnover 32.000
Profit Margin 0.045
Return on Assets 0.126
Return on Equity 0.221
Trimark Industry

Average
Current Ratio 1.766 2.200
Quick Ratio (or Acid Ratio
Test) 1.048 1.500
Cash Ratio 0.108 0.135
Debt Ratio 0.371 0.430
Cash Coverage 37.189 10.600
Day’s Sales in Receivables 16.512 12.000
Total Asset Turnover 2.390 2.800
Inventory
Turnover 28.808 30.100
Day’s Sales in Inventory 12.670 11.500
Receivables Turnover 22.105 30.000
Profit Margin 0.053 0.045
Return on Assets 0.128 0.126
Return on Equity 0.203 0.221
Analysis:
Liquidity: Trimark’s liquidity ratios are below the industry average indicating that they
might need to look into their management of current assets and liabilities.
Leverage: Trimark’s debt ratio is much lower than the industry average and its cash
coverage is more than 3 time the average, indicating that if it needs to borrow long-term
debt it should not have much of a problem.
Asset management: Trimark’s asset turnover ratios are all below the average. It needs to
tighten up collections, and manage its inventory more efficiently.
Profitability: Trimark has a good control on cost of goods sold. Its net profit margin is
better than the industry and so is its ROA. The industry, however, is returning a higher
rate to the shareholders on average, primarily due to the higher debt levels.
5. DuPont Analysis. Based on the ratios calculated in problem 4 above, and in

conjunction with the industry averages given, conduct a DuPont analysis on
Trimark’s key profitability ratios.

According to the Du Pont breakdown, we have
ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier

è ROE = NI/S * S/TA * TA/Equity

Note: since we don’t have the accounting information for the average, we have to figure
out the industry’s equity multiplier by some algebraic manipulation.
Equity Multiplier = Total Assets/Equity
Now, debt ratio = Total Debt/Total Assets
Total Assets = Total Debt + Equity
è (Total Debt/Total Assets) + Equity/Total assets = 1
èEquity/Total Assets = 1 – (Total Debt/Total Assets)èTA/E =
1/(1-TD/TA)
Trimark Industry
Debt Ratio 0.371 0.430
Total Asset Turnover 2.390 2.800
Profit Margin 0.053 0.045
Return on Assets 0.128 0.126
Return on Equity 0.203 0.221
Equity multiplier= 1/(1-debt ratio) 1.59 1.75
Despite a lower Total Asset Turnover ratio, Trimark’s ROA (12.8%) is better than that of
the industry (12.6%), primarily due to its higher net profit margin. The industry, however,
has a higher ROE (22.1%) due to its higher debt ratio and correspondingly higher equity
multiplier.

Chapter 14: Financial Ratios and Firm Performance

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Chapter

©2013 Pearson Education, Inc. Publishing as Prentice Hall

14.2 Financial Ratios (Slides 14-­‐10 to 14-­‐25)

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Table 14.5 indicates that as far as profitability is concerned, Cogswell is outperforming

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14.3 External Uses of Financial

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Prepping for Exams

Year Ending 2011 Year Ending 2010 Year Ending 2009

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TOTAL LIAB & $347,214 $365,469 $387,439

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5. Predicting net income. Below is an abbreviated income statement for Wal-Mart.

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6. Predicting net income. Below is an abbreviated income statement for Starbucks.

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7. Common-size financial statements. Prepare common-size income statements for

8. Common-size financial statements. Below is the balance sheet information on two

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Account B. Sheet Co. 1 % of Total B. Sheet Co. 2 % of Total

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Investments $4,146 8.59% $354 10.64%

Total Liab. &

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For Problems 9 through 12, use the following data:

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Day’s Sales in Inventory = 365 / Inventory Turnover

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06/30/2011 12/31/2010 01/31/2011 06/30/2011 12/31/2010

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Equity 37,385 14,634.20

Times interest Earned = EBIT / Interest Expense

‘000s General Motors Ford Motor Company

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Sales $135,592 $128,974

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Solutions for Advanced Problems for Spreadsheet Application

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Income Statements Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi

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Balance Sheets Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi

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Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Coca-Cola

Ratio or Account 2009 2008 2007

Inventory Turnover Pepsi 7.68 8.07 7.88

Current Ratio Pepsi 1.44 1.23 1.31

Return on Assets Pepsi 14.09% 13.25% 16.34%

Return on Equity Pepsi 33.41% 39.39% 32.83%

Debt to Equity Pepsi 1.37 1.97 1.01

Earnings Per Share Pepsi $ 3.49 $ 2.96 $ 3.51

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14.2 Financial Ratios (Slides 14-‐10 to 14-‐25)

Solutions to Mini-‐Case

ANSWER (Slides 14-‐30 to 14-‐31)

ANSWER (Slides 14-‐32 to 14-‐33)

ANSWER (Slides 14-‐34 to 14-‐35)

ANSWER (Slides 14-‐36 to 14-‐39)

ANSWER (Slides 14-‐40 to 14-‐42)