Financial Statements Analysis Fall term 2022-2023

Tutorial 6

Topics: Long-term debt-paying ability – Profitability

AEG Enterprises Case study:

For the year ended December 31, N, AEG Enterprises presented the financial statements below:

AEG Enterprises

Balance sheet for December 31, N (in thousands of dollars)

Assets
Cash $50 000
Accounts receivable 60 000
Inventory 106 000
Total current assets $216 000
Property, plant and equipment 504 000
Less accumulated depreciation 140 000 364 000
Patents and other intangible assets 20 000
Total assets 600 000
Liabilities and stockholders’ equity
Accounts payable 46 000
Taxes payable 15 000
Other current liabilities 32 000
Total current liabilities 93 000
Long-term debt 100 000
Preferred stock ($100 par, 5% cumulative, 500 000 shares 50 000
authorized and issued)
Common stock ($1 par, 200 000 000 shares authorized, 100 000
100 000 000 issued)
Premium on common stock 120 000
Retained earnings 137 000
Total liabilities and stockholders’ equity 600 000

AEG Enterprises Income statement

For the year ended December 31, N (in thousands of dollars except earnings per share)

Sales $936 000

Cost of sales 671 000
Gross profit 265 000
Operating expenses
Selling $62 000
General 41 000 103 000
Other items
Interest expense 20 000
Earnings before provision for income tax 142 000
Provision for income tax 56 800
Net income 85 200
Earnings per share 0.83

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Financial Statements Analysis Fall term 2022-2023

Additional information:

Item Balance on December 31, N-1

Total assets 560 000
Total operating assets 540 000
Total equity 400 000
Total liabilities 160 000
Intangibles 20 0000
Preferred stock 50 000
Long-term debt 100 000

Required:

a. For the year ended December 31, N, compute and interpret the following ratios:
1. Times interest earned
2. Debt ratio
3. Debt/equity ratio
4. Debt to tangible net worth ratio
5. The Dupont return on assets
6. The Dupont return on operating assets
7. The Return on common equity
8. The return on investment
b. Early in the new year, the officers of the firm formalized a substantial expansion plan. The
plan will increase fixed assets by $190 million. In addition, extra inventory will be needed to
support expanded production. The increase in inventory is purported to be $10 million. The
firm’s investment bankers have suggested the following three alternative financing plans:

Plan A: sell preferred stock at par, 5%

Plan B: sell common stock at $10 per share

Plan C: sell long-term bonds, due in 20 years, at par ($1 000), with a stated interest rate of 8%

Assuming the same financial results and statements balances, except for the increased assets
and financing, compute the Times interest earned, the Debt ratio, the Debt/Equity and the
Debt to tangible net worth ratios under each financing alternative. Do not attempt to adjust
retained earnings for the next year’s profits.

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Financial Statements Analysis Fall term 2022-2023

Solutions:
a.
1. Times interest earned= (85200+56800+20000)/20000= 162000/20000= 8.1 times per year
Income statement perspective of solvency
High and stable ratios are preferred
Recurring earnings cover interest expense 8.1 times.
2. Debt ratio = 193000/600000= 32.2%
Balance sheet perspective of solvency
32.2% of assets are financed through debt.
3. Debt to equity: 193000/407000= 47.4%
Balance sheet perspective of solvency
Total liabilities represent 47.4% of equity
4. Debt to tangible net worth: 193000/(407000-20000)= 49.9%
More conservative balance sheet approach than debt to equity because the ratio omits
intangibles from the net worth of the firm
Debt represents 49.9% of the tangible net worth.
5. Dupont return on assets= Net profit margin x Total asset turnover
Net profit margin=85200/936000= 9.102%
Total asset turnover= 936000/[(600000+560000)/2]=936000/580000=1.613 times per year
Dupont return on assets = 14.681%
For each dollar of average assets, the firm earns 0.146 dollars of net income. The return on
assets could be explained as the product of the net profit margin and the asset turnover. In
fact, assets turnover into sales 1.613 times per year, which means that one dollar of average
assets generates 1.613 dollars of sales.
Net income represents 9.102% of sales
Therefore, the overall return on assets is the outcome of the efficiency of using assets to
generate sales and the efficiency to convert the resulting sales into net income.
6. Operating income = gross profit – operating expenses = 265000 – 103000= 162 000
Operating assets = total assets – intangibles=600000-20000=580000
Dupont return on assets= operating margin x operating assets turnover
Operating margin = 162000/936000=17.307%
Operating assets turnover = 936000/[(580000+540000)/2]= 936000/560000=1.671 times per
year
Dupont return on operating assets: 28.921%
The company earns 0.289 dollars of operating income for each dollar of average operating
assets. The return is the outcome of the ability to make sales from operating assets (each
dollar of average operating assets generates 1.671 dollars of operating income). Moreover,
operating income represents 17.307% of sales.
The Dupont return on operating assets is a better indication (than the Dupont return on
assets) of the profitability of the main operations of the firm. It measures the overall return
on operating assets as the outcome of the efficiency of using operating assets to generate
sales and the efficiency to convert the resulting sales into operating income. It is higher than
the Dupont return on assets because of the higher operating margin ratio. Almost all assets
are operating assets (except intangibles) but the operating income is much higher than the
net income.

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Financial Statements Analysis Fall term 2022-2023

7. Return on common equity= (Net income -Preferred dividends)/Average common equity

Return on common equity=(85200-50000x5%)/[357000+(400000-50000)]/2
= (85200-2500)/353500=82700/353500=23.394%
Common shareholders earn 23.394% on their investment in common shares. One dollar
invested in common shares generates 0.239 dollars of net income.
8. Let’s calculate the effective tax rate: 56800/142000=40%
Numerator: 85200+20000x(1-0.4)= 97200
Denominator: (407000+100000+400000+100000)/2=503500
ROI= 19.304%
The firm rewards its long-term providers of funds with a return rate of 19.304%. In other
words, each dollar invested in equity by shareholders or provided as long-term debt by
creditors generates 0.193 dollars of income.
b. New value of assets under all plans (increase of 200000): 800 000
Inventories increase by 10000 and noncurrent assets increase by 190 000
Plan A:

Current liabilities 93 000

Long term debt 100 000
Preferred stock 50000+200000= 250 000
Common equity 357 000
Total liabilities and equity 800 000

Net income is unchanged 85 200

Plan B:

Current liabilities 93 000

Long term debt 100 000
Preferred stock 50 000
Common stock (at par) Number of common shares issued to finance the
expansion: 200000/10=20000 shares
Par value of new common shares: 20000x1=20000
So common stock at par: 100000+20000=120000
Premium on common stock Premium on additional common shares:
20000x(10-1)=180000
So total premium on common stock=
120000+180000=300000
Retained earnings 137 000
Total liabilities and equity 800 000

Net income is unchanged 82 500

Plan C

Current liabilities 93 000

Long term debt 100 000+200 000= 300 000
Preferred stock 50000
Common equity 357 000
Total liabilities and equity 800 000

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Financial Statements Analysis Fall term 2022-2023

Operating income is unchanged: 162 000

Interest expense will increase: 20 000+8%200000=20000+16000=36000
So new earnings before taxes:162 000-36000= 126 000
Taxes: 40%x126000= 50 400
New net income: 126 000-50 400=75 600

Ratio Plan A Plan B Plan C

Times interest earned 8.1 times per year 8.1 times pear year 4.5 times per year
Debt ratio 24.1% 24.1% 49.1%
Debt/equity 31.8% 31.8% 96.6%
Debt to tangible net worth 32.9% 32.9% 101.6%

We notice that the debt alternative significantly worsens the long-term debt-paying ability
with a material decrease in times interest earned and an important increase in all ratios
related to the balance sheet perspective of long-term debt. The recourse to debt increases
risk from a creditor’s perspective.