Chapter 4 Analysis of Financial Statements

Answers to End-of-Chapter Questions

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The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio. The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing. Given that sales have not changed, a decrease in the total assets turnover means that the company’s assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies that the company increased its current assets. Since the company’s current ratio increased, and yet, its cash and equivalents and DSO are unchanged means that the company has increased its inventories. This is also consistent with a decline in the total assets turnover ratio. Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin, and vice versa. Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the book value of the assets that produced the sales and the annual depreciation expense remain at historic values and do not reflect the actual cost of replacing those assets. Thus, ratios that compare current flows with historic values become distorted over time. For example, ROA will increase even though those assets are generating the same sales volume. When comparing different companies, the age of the assets will greatly affect the ratios. Companies with assets that were purchased earlier will reflect lower asset values than those that purchased assets later at inflated prices. Two firms with similar physical assets and sales could have significantly different ROAs. Under inflation, ratios will also reflect differences in the way

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Chapter 4: Analysis of Financial Statements

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

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Chapter 4: Analysis of Financial Statements

The estimated taxes payable are increased. A fully depreciated asset is retired. Short-term promissory notes are issued to trade creditors in exchange for past due accounts payable. r. Advances are made to employees. 10-year notes are issued to pay off accounts payable. 0 – m.j. 0 0 0 0 + 0 Chapter 4: Analysis of Financial Statements Answers and Solutions 3 . p. l. Marketable securities are sold below cost. Accounts receivable are collected. Equipment is purchased with short-term notes. n. 0 o. q. Short-term notes receivable are sold at a discount. Merchandise is purchased on credit. – – Total Current Assets – – Current Ratio 0 – 0 + 0 0 – – – – – Effect on Net Income 0 – 0 0 0 0 0 0 – k. s. t. Current operating expenses are paid.

CL = $1.300.000.000.Solutions of End-of-Chapter Problems 4-1 DSO = 40 days. M/B = ? Book value = $6. ROE = NI/E.000 M/B = $32.000.000.000. A 4-3 ROA = 10%.000. AR = ? DSO = 40 = AR S 365 AR $7.000. TA = $10.000 = $7.000 AR = $800. TA/E = ? ROA = NI/A. PM × S/TA × TA/E NI/S × S/TA × TA/E 2% × 5 × TA/E 10% × TA/E EM = 1.5. Shares outstanding = 800. LT debt = $3. S = $7.000. P0 = $32.000. $7.300.000.2667. D/A = ? D  = 1 − A  D  = 1 − A  1   A/E  1   2.33%. 800.000.4  D = 0.000.000. ROA NI/A 10% S/TA ROE NI/E 15% 15% TA/E 4-4 = = = = = = = = = PM × S/TA NI/S × S/TA 2% × S/TA TATO = 5.000. 4-2 A/E = 2.000. CE = $6.50. ROE = 15%.000.000.5833 = 58. PM = 2%.50 4 Answers and Solutions Chapter 4: Analysis of Financial Statements . PM = NI/S.00 = 4.000.000. S/TA = ?.000 /365 40 = AR/$20.4.

0× .00/$50. P/E = ? P/CF = 8.000 + $923.000. Sales = $100. TA = ? ROA = NI TA $600.000/0.4NI 0. net income = $600.500 = NI.000 × 0.12 = $6. P/CF = 8. ROE = ? ROE = = = = PM × TATO × EM NI/S × S/TA × A/E 2% × $100.000.0 P = $24.500. 4-8 ROA = 8%.000 ($225.0 P/$3.2× = Assets Assets = $1.500.0× .000.000 3.077 323.500 6. ROE = NI/S × S/TA × TA/E 0.000 × 2 8%.875.4-5 EPS = $2.000.077 $ 600.00 = 8.000.000.000. 4-7 Step 1: Calculate total assets from information given.875.077) (Given) $600. Sales = $6 million.00.2× = Sales/TA $6. To calculate EBIT construct a partial income statement: EBIT Interest EBT Taxes (35%) NI $1.000. There is 50% debt and 50% equity. so Equity = $1.4NI $112. To calculate BEP.000/$937.000.00.00. 3.2 × $1.000.00/$2. CFPS = $3.000 $720.5 = $937.148. Assets = $50.000 = 6.000 8% = TA TA = $7.000 $ 923.875.12 = NI/$6. we still need EBIT.000.000.65 Chapter 4: Analysis of Financial Statements Answers and Solutions 5 . P/E = $24.077 225. Step 2: Calculate net income.000 × 3. EM = 2.0. 4-6 PM = 2%.00 = 12.

148.5) Profit margin = 3%/1.000.40 = 40%.000.000. therefore.125.9) = $7.125.000 = $75. so A A NI A A E 1 = 3% × A 0.750.31%.50. using the DuPont equation: ROE = ROA × EM 5% = 3% × EM EM = 5%/3% = 5/3 = TA/E. Take reciprocal: E/TA = 3/5 = 60%.05 E = 60% .000. Market value per share = $75(1.40 = 40%. We can also calculate the company’s debt ratio in a similar manner.60 = 0.000 = 0.000/50.000.750. Market value per share = $7. given the facts of the problem.5× .BEP = EBIT TA $1.60 = 0.1531 = 15.9) = $142.000. P = ? Book value per share = $3. Shares outstanding = 50.000.000. 6 Answers and Solutions Chapter 4: Analysis of Financial Statements . the firm’s profit margin = 2% and its debt ratio = 40%. P = ? Total market value = $3.5 = 2%. 4-10 We are given ROA = 3% and Sales/Total assets = 1.000(1.000.000 = $142. if we use the reciprocal of ROE we have the following equation: E NI E D E = × and = 1 − .500. Alternative solution: Stockholders’ equity = $3.9.750.000.000/50.000. Thus. 4-9 Stockholders’ equity = $3.50.077 = $7. A Alternatively.750.000. D/A = 1 – 0. We are given ROA(NI/A) and ROE(NI/E). A D = 1 − 0. From the DuPont equation: ROA = Profit margin × Total assets turnover 3% = Profit margin(1.000. M/B = 1.

000. 4-12 TIE = EBIT/INT.6 400.000 See above. Net income = $2.000. ROA = 5%. TIE = EBIT/INT = $1.000 EBIT = $1. EBIT/TA = 15%.000 × 0.000.000.000.000 Now we can use some ratios to get some more data: Total assets turnover = 2 = S/TA.000.000/(1 – T) = $100.000 na $ 1.800.7 = $142.000.000 $ 700. TA = S/2 = $10.857.000/0.15 $12.000.000 × 0.05 $12.000.800.000/$800.000 See above. Interest = $500. TIE = $192.000.000.000 238. EBIT INT EBT Taxes (40%) NI INT = EBIT – EBT $1.000 NI = $600.000/0.857 + $50. 4-13 ROE = Profit margin × TA turnover × Equity multiplier = NI/Sales × Sales/TA × TA/Equity.000 EBT = $600.25.000.000.000. EBIT = EBT + Interest = $142.000.800.000. Chapter 4: Analysis of Financial Statements Answers and Solutions 7 .000 = 3.000.000 = 2.86× .000. and we put numbers in it on the right: Sales (given) – Cost EBIT (given) – INT (given) EBT – Taxes (34%) NI $10.000 $ 600.1 = $50.000.000.000. NI = 0. = $1.000 300.000 – $1.000. Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.000 $ 462. Now we need to determine the inputs for the Du Pont equation from the data that were given.000.05 = $100.000 = $192. On the left we set up an income statement.000. T = 40%. so find EBIT and INT.000/2 = $5.000 $1.000.000.800.4-11 TA = $12.000.000.000. Pre-tax income (EBT) = $100.000.000 800.857/$50.000.857. TIE = ? EBIT = 0.

2 = EBIT/Total assets.000.000 = 12% $1.000 $120.000 $120.000.000 – $125.2% $500.000* $160.5× . This is the level of current assets that will produce a current ratio of 2.000 80. At present.000.08 = $40. then the new common equity balance will be $200. rate(added assets). so we can solve to find the new level of current assets: CA = 2. so Equity = $500. ROE is ROE1 = $15. therefore.000 – $85. if pre-tax income 8 Answers and Solutions Chapter 4: Analysis of Financial Statements . and.04%.000 − $65.000. (4) Pre-tax income will rise by the amount (added assets)(BEP – Int. 4-14 Currently. *If D/A = 50%. Assuming that net income is unchanged.000 = 7.000 = 19.5 = 50%.000.5 = 0. current assets amount to $210.000 = $65. rate. Thus.50% = 5.000 × 0. so Debt = $500. rate = 8%.000 = $50.000 = 1.000 × $10. D/A = 0.000.000/$5. Refer to the solution setup for Problem 4-15 and think about it this way: (1) Adding assets will not affect common equity if the assets are financed with debt.000 0 $200.000 64.4 = 2.2($1.000 Difference in ROE = 19. (2) Adding assets will cause expected EBIT to increase by the amount EBIT = BEP(added assets).000.2× .000) = $200. EBIT Interest EBT Tax (40%) NI ROE = NI = Equity D/A = 0% $200.231 = 23. Equity multiplier = TA/E = 1/(E/A) = 1/0.000. so E/A = 40%. At an 8% interest rate.1%.000.2% – 12.000. T = 40%.5 = CA/CL.5(CL) = 2. so EBIT = 0. (3) Interest expense will increase by the amount Int.000 40.000.000. rate).D/A = 60%.000. CL is $50. then half of the assets are financed by debt. and it will not change. the new ROE will be ROE2 = $15. If the $85. Now we can complete the DuPont equation to determine ROE: ROE = $462.000.000.000 generated is used to retire common equity.000/$10.000. CL remain at $50.000 – $85.000.000 $ 96. The new CA level is $125.000 × 2.000/$115. INT = $500. 4-16 Statement a is correct. and the new Inventory level = $150.000. BEP = 0.000.5%. 4-15 Known data: TA = $1.0% = 7.54%.04% – 7.000 $96.5($50.000 D/A = 50% $200. Assuming BEP > Int.000/$200. Therefore.000 = 13.2%.5. so they can be reduced by $210. The current ratio will be set such that 2. Int.000 = $115. ROE will increase by 13.000) = $125. the new quick ratio is calculated as follows: New quick ratio = CA − Inv CL $125.000 = $85.

000. the inventory account will increase to $637.000 + ∆NP 4-18 Present current ratio = Minimum current ratio = $1.000/$83.6 See above. and d are false.increases so will net income.500 without violating a 2 to 1 current ratio.000. because the BEP ratio uses EBIT. Statement e is also false.0. Chapter 4: Analysis of Financial Statements Answers and Solutions 9 .000.000 EBIT = $500. then adding assets financed by debt would lower net income and thus the ROE.666.312.000. and if the expected BEP on those assets exceeds the interest rate on debt.000 83.333 = 6.500 + ∆NP = $1.000. Statements b. Of course.667 166. TIE = EBIT/INT = $500. TIE ? EBIT = 0.050.000.000 + 2∆NP ∆NP = $262.500 + ∆NP = 2. Short-term debt can increase by a maximum of $262.000.666.000. Statement a is true—if assets financed by debt are added.000.0. $525.000 $1.5.000 . EBIT/TA = 10%.500 = 2. which is calculated before the effects of taxes or interest charges are felt. Therefore. Since we assumed that the additional funds would be used to increase inventory.312.333.333 $416.000 NI = $250.500. and current liabilities will total $787.500 and current assets will total $1.667 $250.000.333.10 $5.05 $5.500.000.667 EBT = $250.000. T = 40%. NI = 0. $525. Note that if Int. INT = EBIT – EBT = $500. assuming that the entire increase in notes payable is used to increase current assets. $1.000. then the expected ROE will also increase.000. c.000. then the firm’s ROE will increase. (5) If expected net income increases but common equity is held constant. EBIT INT EBT Taxes (40%) NI $500.000/0.$416. rate > BEP.575.666. ROA = 5%.000 See above. Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.312.000. 4-17 TA = $5.000.

000. Cash + Accounts receivable + Inventories Cash + $45.000.000.000 + $45.000 + $90. Accounts receivable = (Sales/365)(DSO) = ($450. Again. 2. + Inventories) = $300.000) = $450.5) = $45. Accounts payable = Total debt – Long-term debt= $150. Common stock = Total liabilitie s and equity – Debt – Retained earnings = $300.500 = $52.272.50)($300.750.000 $27.000) = $150. Total debt = (0.682.681. 3.000 – $97. 10 Answers and Solutions Chapter 4: Analysis of Financial Statements . 9.000/650. The current P/E ratio is then $40/$4 = 10. 8. The new number of shares outstanding will be 650.75) = $337.000/500.000 Cash + $135.250. using the DSO equation.000.8)($90. 6. Step 2: If sales fall by 15%.000 Cash = = = = (1. the new sales level will be $4.230.590.000. Thus.681.73(0. 5. Sales = (1. 4-21 4.5)($300.85) = $4.000/365)(36.000/5 = $90.977.000 = $5. If the shares are selling for 10 times EPS.000 – $60. 4-20 The current EPS is $2.00. solve for the new accounts receivable figure as follows: 35 = AR/($4.00.000.000 shares or $4. Fixed assets = Total assets – (Cash + Accts rec.000.000) $162.000 – ($27.000 Sales= $4.73.000)(0.82.000 = $90. Inventories = Sales/5 = $450. Cost of goods sold = (Sales)(1 – 0. 1.500. the new EPS = $3.000. 7.272.681. then they must be selling for $5.230.00(10) = $50.5)(Total assets) = (1.91 AR = $405.000 + $90.00.000/(Sales/365) 55Sales = $273.000 – $150.82/365) 35 = AR/$11.000) = $138.500.25) = ($450.000.50)(Total assets) = (0.82 ≈ $405.4-19 Step 1: Solve for current annual sales using the DSO equation: 55 = $750.8)(Accounts payable) (1.977.

4-22 a.9% Chapter 4: Analysis of Financial Statements Answers and Solutions 11 .300 $361.607.000 $330. Potential investors who look only at 2008 ratios will be misled.404. ratios based on this year will be distorted and a comparison between them and industry averages will have little meaning.9% = 7.500 $241.40 = 2. the company seems to be in an average liquidity position and financial leverage is similar to others in the industry.500 $330.) Firm Current assets Current liabilities Current assets − Inventorie s Current liabilities DSO = Accounts receivable Sales/ 365 Sales Inventories Sales Total assets Net income Sales Net income Total assets Net income Common equity Total debt Total assets b.0% 60. For the firm.500 = 1. So. c.5 = 9%. (Dollar amounts in thousands.A.66× = 1.11 $1.5 = Total assets/Common equity.2% × 3 × 2.2% 3. recognize that 1 – (Total debt/Total assets) = Common equity/Total assets. indicating that the firm should tighten credit or enforce a more stringent collection policy.70× = 1.000 = = = = = = = = = $655.0× 1.500 $947. and a return to normal conditions in 2009 could hurt the firm’s stock price.000 − $241.6% = 61.6%.500 $27.0% = 6.300 $1.000 $655. The total assets turnover ratio is well below the industry average so sales should be increased. ROE = 1. However. Note: To find the industry ratio of assets to common equity. d.000 $4.000 $336.3× 35 days 6. ROE = PM × T.0× 1.7 × For the industry.6% 9.7% × 1.3 days Industry Average 2. and 1/0. If 2008 represents a period of supernormal growth for the firm. assets decreased. $361.500 $947. or both.500 = 7.98× = 1.607.25× = 76. The firm’s days sales outstanding ratio is more than twice as long as the industry average.500 $27. its other profitability ratios are low compared to the industry—net income should be higher given the amount of equity and assets.500 $1.607. turnover × EM = 1.7× 3. Common equity/Total assets = 40%. While the company’s profit margin is higher than the industry average.000 $586.300 $947. $947.7% = 2.500 $27.

A.41× = 1.6%.57% ≈ 8.57% = 6% × 1.4% × 1.5 $61.5 $795 $159 $66 $795/365 $795 $147 $795 $450 $27 $795 $27 $450 = 2. $795 $450 $315 12 Answers and Solutions Chapter 4: Analysis of Financial Statements . Equity $315 b.5 $6. A.5 $4. + Lease pymts pymts Sales Inventories Accounts receivable Sales/ 365 Sales Net fixed assets Sales Total assets Net income Sales Net income Total assets ROA × EM = = = $303 $111 $135 $450 $49.00% 7× = = = 9.46× 9× = = = = = = = = = = = = = = 5× = 30.00% 12.00% = 11× Industry Average 2× 30. ROE = = = = Current assets Current liabilities Debt Total assets EBIT Interest EBITDA + Lease pymts INT + Princ.40% = 6. turnover T.77 × 1. ROE = Profit margin × Total assets turnover × Equity multiplier Total assets Net income Sales = × × Common equity Sales Total assets $27 $795 $450 = × × = 3.4286 Net income $27 = = 8. turnover Profit margin Return on total assets Return on common equity Alternatively.77× = 3.4286 = 8.73× = 30.86% = 5.4-23 a.6%.00% 9.00% = 8. Firm Current ratio Debt to total assets Times interest earned EBITDA coverage Inventory turnover DSO F.3 days 10× 24 days 6× 3× 3.

0× 1.86%/9% = 1. and common equity. inventories. It is possible to correct for such problems by using average rather than end-of-period figures. or the firm is carrying more assets than it needs to support its sales. 0. d. this is not nearly as clear-cut as the overinvestment in inventory.4% 1. thus reducing interest charges and improving profits.K. and current liabilities. The comparison of inventory turnover ratios shows that other firms in the industry seem to be getting along with about half as much inventory per unit of sales as the firm.30 = 0.7 TA 1 EM = = = 1. as shown by a slightly lower-than-average fixed assets turnover ratio. e.4286* Comment Good Poor O. D E = TA TA 1 – 0.7 E Alternatively.4286 ≈ 1. If the company’s inventory could be reduced. profits. this would generate funds that could be used to retire debt. Ratios involving cash.77× 1. However. If the firm had a sharp seasonal sales pattern.43. c.4286 Industry 3.43. as well as those based on sales. receivables. EM = ROE/ROA = 12. could be biased. Analysis of the DuPont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low.4289 ≈ 1. Chapter 4: Analysis of Financial Statements Answers and Solutions 13 . or if it grew rapidly during the year. Either sales should be higher given the present level of assets. and strengthening the debt position. many ratios might be distorted. There might also be some excess investment in fixed assets.0% 3. perhaps indicative of excess capacity.Profit margin Total assets turnover Equity multiplier *1– Firm 3.

43% 54.76% 11. they are still below industry averages.47% 2.79 9. its DSO was close to the industry average. and total assets turnover have improved from 2007 to 2008.0 3.00% 2. which is bad. In 2008.11 4. this will make its current ratio look worse than what was calculated above.94 7. Given its weak current and asset management ratios. its DSO is somewhat higher. Corrigan's debt ratio has increased from 2007 to 2008. a. the firm should strengthen its balance sheet by paying down liabilities. 4-24 Ratio Analysis Liquidity Current ratio Asset Management Inventory turnoverb Days sales outstanding Fixed assets turnover b c 2008 2.33 4.5% 50.60 2007 2. 14 Comprehensive/Spreadsheet Problem Chapter 4: Analysis of Financial Statements . but in 2008 it is higher than the industry average.7 7. Based on year-end balance sheet figures.81% 15.Comprehensive/Spreadsheet Problem Note to Instructors: The solution to this problem is not provided to students at the back of their text.89 2.31 1. its debt ratio was right at the industry average.81% 5. Instructors can access the Excel file on the textbook’s web site or the Instructor’s Resource CD.47 32.18 5. Calculation is based on a 365-day year. If the firm's credit policy has not changed.6 9. however.1% 18. it needs to look at its receivables and determine whether it has any uncollectibles.65 2. however.0% 6.5 Total assets turnover Profitability Return on assets Return on equity Profit margin on sales Debt Management Debt ratio Market Value P/E ratio Price/cash flow ratio a b c b Industry average ratios have been constant for the past 4 years.74 37.84 2.64% 49. its current ratio is still below the industry average of 2. b.7. If it does have uncollectible receivables.43 1. Corrigan's liquidity position has improved from 2007 to 2008. Corrigan's inventory turnover.0 32 13. In 2007.22% 0.0 2. The firm's days sales outstanding ratio has increased from 2007 to 2008—which is bad. fixed assets turnover.16 Industry Avga 2. c. In 2007.2% 3.

f.22% 11. but only because its net income has declined significantly from the prior year. Corrigan's profit margin is significantly lower than the industry average and it has declined substantially from 2007 to 2008.43% 2. and they are substantially below the industry averages. If Corrigan initiated cost-cutting measures. Its P/CF ratio has declined from the prior year and is well below the industry average.20% PM x 0. Corrigan's profitability ratios have declined substantially from 2007 to 2008.60 x Equity Multiplier 2. g.18 2. lower its debt ratio. e.00 Looking at the extended DuPont equation. Reducing costs and lowering inventory would also improve its debt ratio. These ratios reflect the same information as Corrigan's profitability ratios.47% 18. and improve its asset management.d. If Corrigan also reduced its levels of inventory. and improve its asset management by either using less assets for the same amount of sales or increase sales. increase sales. increase sales. 2008 2007 Industry Avg. or both. ROE = 2.5% TA Turnover 2. The firm's total assets turnover has improved slightly from 2007 to 2008. lower its debt ratio.21 1. this would improve its current ratio—as this would reduce liabilities as well.64% 3. Corrigan needs to reduce its costs. The firm's equity multiplier has increased from 2007 to 2008 and is higher than the industry average. Chapter 4: Analysis of Financial Statements Comprehensive/Spreadsheet Problem 15 . This would improve its profitability ratios and market value ratios. Corrigan's P/E ratio has increased from 2007 to 2008. but it's still below the industry average. this would increase its net income. This indicates that the firm's debt ratio is increasing and it is higher than the industry average. Corrigan should increase its net income by reducing costs. Corrigan needs to reduce costs to increase profit.31 2.99 2. This would also improve its inventory turnover and total assets turnover ratio.

D’Leon had increased plant capacity and undertaken a major marketing campaign in an attempt to “go national. and for the new manufacturing facilities to operate 16 Integrated Case Chapter 4: Analysis of Financial Statements . for the new sales offices to generate sales. costs have been higher than were projected. discussed the situation of D’Leon Inc.Integrated Case 4-25 D’Leon Inc.. D’Leon’s chairman. its managers. Thus. presented in Chapter 3.” Jamison examined monthly data for 2008 (not given in the case). and large losses in the early months had turned to a small profit by December. who had the task of getting the company back into a sound financial position. Table IC 4-3 gives the company’s 2007 and 2008 financial ratios. D’Leon’s 2007 and 2008 balance sheets and income statements. assuming that some new financing is arranged to get the company “over the hump. are given in Tables IC 4-1 and IC 4-2. Also. together with projections for 2009. In addition. after an expansion program. costs were falling. and she detected an improving pattern during the year. As a result. and investors are concerned about the firm’s survival.” Thus far. Monthly sales were rising. a regional snack foods producer. it appears to be taking longer for the advertising program to get the message out. the annual data look somewhat worse than final monthly data. sales have not been up to the forecasted level. Part II Financial Statement Analysis Part I of this case.. Donna Jamison was brought in as assistant to Fred Campo. The 2009 projected financial statement data represent Jamison’s and Campo’s best guess for 2009 results. and a large loss occurred in 2008 rather than the expected profit. together with industry average data. directors.

Balance Sheets 2009E 2008 $ 7.600 351.000 491.800 400.800 $ 1.650.592 $ 2.800 300.716. Your assignment is to help her answer the following questions. Jamison and Campo see hope for the company—provided it can survive in the short run.432 460.800 Assets Cash Accounts receivable Inventories Total current assets Gross fixed assets Less accumulated depreciation Net fixed assets Total assets Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term debt Common stock Retained earnings Total equity Total liabilities and equity $ 85.866.144.497.200 715.480 $ 2.352 $ 3.568 723.120 $ 817.000 1.160 $ 939.950 263.432 460. and what actions should be taken.680.176 $ 1. The 2009 data are forecasts.152 $ 436.800 Note: “E” indicates estimated. not yes or no answers. the lags between spending money and deriving benefits were longer than D’Leon’s managers had anticipated.000 $ 1.160 380.000 32.768 $ 1. Table IC 4-1.160 1.468.497. For these reasons.952.040 $ 3.112 1. what it must do to regain its financial health.721. In other words.287.202.000 1.360 $ 1.200 $ 344. Jamison must prepare an analysis of where the company is now.160 636.000 146.592 $ 492.600 $ 1.152 $ 524.926.124.592 $ 145.197.600 323.000 $ 481.000 136. Chapter 4: Analysis of Financial Statements Integrated Case 17 .200 $ 1.176 231.000 408.866. Provide clear explanations.592 $ 2007 57.790 $ 2.600 200.632 878.768 $ 663.802 1.282 632.000 203.efficiently.468.808 489.

600 58.425.000 0 2008 $ 6.992 550.948) 136.056 $ 253.220 6.000 2.988 ($ 13.672 $ 3.Table IC 4-2.00% 40.988) 116.960 ($ 130.960) (106.672 $ 209.176 ) ($ $ $ $ 1.110 4.602) 0.17 250.600 5.000 5.034.000 358. The 2009 data are forecasts.608 116.012 ($ 266.000 40.875.584 $ $ $ $ 1.432.648 70.988 $ 6.640 169.000 519.638 8. Income Statements Sales Cost of goods sold Other expenses Total operating costs excluding depreciation EBITDA Depreciation EBIT Interest expense EBT Taxes (40%) Net income EPS 0.328 18.828 $ 146.008 $ 422.864.000 40.528.992 $ 609. a The firm had sufficient taxable income in 2006 and 2007 to obtain its full tax refund in 2008.960 $ 492.000 0 $ $ $ 2007 $ 3.880 2009E $ 7.220 7.50 100.222.000 40.900 $ 190.000 0 DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments Note: “E” indicates estimated.960 $ 0.00% 40.035.784 ) a ($ 160.926 2.428 43.809 12.00% 40. 18 Integrated Case Chapter 4: Analysis of Financial Statements .25 100.047.000 $ 6.014 0.640 $ 87.

8× 37. a Calculation is based on a 365-day year. Why are ratios useful? What are the five major categories of ratios? Answer: [S4-1 through S4-5 provide background information.0× 6.8% 4.] Ratios are used by managers to help improve the firm’s performance.0% 6.0% 6.7× 1. and market value.2% 14.0 7.8% -1.4× n.1× 82.6% 2. by lenders to help evaluate the firm’s likelihood of repaying debts.7% -4.2% -2.0× 2.4× 2.1% 18.3% 3. Chapter 4: Analysis of Financial Statements Integrated Case 19 .2 6.3% 9. debt management.2× 2.3× 0.0× -2.6% -32. The five major categories of ratios are: liquidity.6% 13.3× 54.2× 0.3× 5.93 2007 2. asset management. and by stockholders to help forecast future earnings and dividends.4× 0.0× 2.64 Industry Average 2. Then.5% -1. Ratio Analysis 2009E Current Quick Inventory turnover Days sales outstanding (DSO) a Fixed assets turnover Total assets turnover Debt ratio TIE Operating margin Profit margin Basic earning power ROA ROE Price/earnings Market/book Book value per share 2008 1.2× 7.8× 4.1% 9. A.1× 32.7× 38. show S4-6 and S4-7 here.6× 50.a.5× $4.7× 1. profitability.5% 19.Table IC 4-3. The 2009 data are forecasts. Note: “E indicates estimated.0% 13.4× 4.4 10.6% -5.3× $6.

680.632/$1. and as projected for 2009? We often think of ratios as being useful (1) to managers to help run the business.480)/$1. However. and total assets turnover. days sales outstanding (DSO). The company’s current and quick ratios are identical to its 2007 current and quick ratios.600/$1.144. Calculate the 2009 inventory turnover.144. Would these different types of analysts have an equal interest in these liquidity ratios? Answer: [Show S4-8 and S4-9 here. How does D’Leon’s utilization of assets stack up against other firms in its industry? Answer: [Show S4-10 through S4-15 here. fixed assets turnover.] Current ratio 09 = Current assets/Current liabilities = $2.10× . 2008. and they have improved from their 2008 levels.B.716. What can you say about the company’s liquidity positions in 2007.800 = $963.035.144. 20 Integrated Case Chapter 4: Analysis of Financial Statements .800 = 0.680.] Inventory turnover 09 = Sales/Inventory = $7.480 = 4. C.800 = 2. Quick ratio 09 = (Current assets – Inventories)/Current liabilities = ($2.842× .112/$1. both the current and quick ratios are well below the industry averages. (2) to bankers for credit analysis.34× .112 – $1. Calculate D’Leon’s 2009 current and quick ratios based on the projected balance sheet and income statement data. and (3) to stockholders for stock valuation.716.

) D.600/$3. or that D’Leon’s cost of fixed assets were lower than most firms in the industry.000)/$3. the firm’s 2009 total assets turnover ratio is only slightly below the 2008 level.152 = 2. The firm’s inventory turnover and total assets turnover are below the industry average.035.152 = 44.04× .497. its fixed assets are older and thus have been depreciated more.035. The firm’s days sales outstanding ratio is above the industry average (which is bad).035.144.] Debt ratio 09 = Total debt/Total assets = ($1. Total assets turnover 09 = Sales/Total assets = $7.DSO 09 = Receivables/(Sales/365) = $878.008 = 7. in which case.600/365) = 45.17%. The firm’s inventory turnover and total assets turnover ratios have been steadily declining. however. (This might be due to the fact that D’Leon is an older firm than most other firms in the industry.800 + $400. The firm’s fixed assets turnover ratio is below its 2007 level. however.497.61× . the firm’s fixed assets turnover is above the industry average. How does D’Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios? Answer: [Show S4-16 and S4-17 here. Fixed assets turnover 09 = Sales/Net fixed assets = $7.55 days. However.648/$70.600/$817. it is above the 2008 level.01× . Calculate the 2009 debt and times-interest-earned ratios. Chapter 4: Analysis of Financial Statements Integrated Case 21 .000/($7. while its days sales outstanding has been steadily increasing (which is bad). TIE 09 = EBIT/Interest = $492.040 = 8.

952. it is slightly below its 2007 level and still well below the industry average.60%.600 = 7.25%. however. basic earning power (BEP).600 = 3. Profit margin 09 = Net income/Sales = $253.99% ≈ 13. return on assets (ROA). ROA 09 = Net income/Total assets = $253.0%. they are still below the industry averages. and it is below the industry average (which is good). The firm’s operating margin is above 2007 and 2008 levels but slightly below the industry average.584/$3.497. Calculate the 2009 operating margin.497. The firm’s ROE ratio is greatly improved over its 2008 level.The firm’s debt ratio is much improved from 2008 and 2007.152 = 7.584/$7. and return on equity (ROE).584/$1. ROE 09 = Net income/Common equity = $253.] Operating margin 09 = EBIT/Sales = $492.035.00%. profit margin. 22 Integrated Case Chapter 4: Analysis of Financial Statements . E.152 = 14.352 = 12. While the firm’s basic earning power and ROA ratios are above 2007 and 2008 levels. What can you say about these ratios? Answer: [Show S4-18 through S4-24 here.648/$3. The firm’s TIE ratio is also greatly improved from its 2007 and 2008 levels and is above the industry average.09%. Basic earning power 09 = EBIT/Total assets = $492. The firm’s profit margin is above 2007 and 2008 levels and slightly above the industry average.648/$7.035.

96% ≈ 13.952.17/$1.56× .17/$7. BVPS 09 = Common equity/Shares outstanding = $1. Calculate the 2009 price/earnings ratio and market/book ratio. if the firm’s assets were older than other firms in its industry this could possibly account for the Chapter 4: Analysis of Financial Statements Integrated Case 23 .000 = $7. However.] EPS 09 = Net income/Shares outstanding = $253.] Equity Profit Total assets DuPont equation = margin × turnover × multiplier = 3. Check: Price = EPS × P/E = $1.4417) = 12.60% × 2.01 × 1/(1 – 0.584/250. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Answer: [Show S4-25 and S4-26 here.81.352/250.0) = $12. G. The P/E and M/B ratios are above the 2008 and 2007 levels but below the industry average.0143 = 12.0143. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2009.17.0%. What are the firm’s major strengths and weaknesses? Answer: [Show S4-27 and S4-28 here. Market/Book 09 = Market price per share/Book value per share = $12.000 = $1.0143(12.81 = 1. Price/Earnings 09 = Price per share/Earnings per share = $12. Strengths: The firm’s fixed assets turnover was above the industry average.F.0× .

how would that change “ripple through” the financial statements (shown in thousands below) and influence the stock price? Accounts receivable Other current assets Net fixed assets Total assets $ 878 1. and its debt ratio has been greatly reduced.952 Liabilities plus equity $3. and its market value ratios are low. (D’Leon’s fixed assets would have a lower historical cost and would have been depreciated for longer periods of time.545 Equity 1. so it is now below the industry average (which is good).6 days to the 32-day industry average without affecting sales. if the company could improve its collection procedures and thereby lower its DSO from 45. For example.) The firm’s profit margin is slightly above the industry average.497 Debt $1. how an improvement in the DSO would tend to affect the stock price. Weaknesses: The firm’s current asset ratio is low. which has improved the firm’s TIE ratio so that it is now above the industry average. in general terms. This improved profit margin could indicate that the firm has kept operating costs down as well as interest expense (as shown from the reduced debt ratio). H. Use the following simplified 2009 balance sheet to show. most of its profitability ratios are low (except profit margin).802 817 $3.higher ratio.497 24 Integrated Case Chapter 4: Analysis of Financial Statements . most of its asset management ratios are poor (except fixed assets turnover). Interest expense is lower because the firm’s debt ratio has been reduced.

820 = $261. The freed up cash could be used to repurchase stock. this would improve the current asset ratio.035. expand the business. Freed cash = old A/R – new A/R = $878.62. Does it appear that inventories could be adjusted? If so.Answer: [Show S4-29 through S4-32 here.275. and reduce debt. the inventory and total assets turnover.600/365 = $19. Reducing accounts receivable and its DSO will initially show up as an addition to cash. Chapter 4: Analysis of Financial Statements Integrated Case 25 . how should that adjustment affect D’Leon’s profitability and stock price? Answer: The inventory turnover ratio is low.180. which should improve the firm’s stock price and profitability. It appears that the firm either has excessive inventory or some of the inventory is obsolete. Accounts receivable under new policy = $19. I.62 × 32 days = $616. All of these actions would likely improve the stock price. If inventory were reduced. and reduce the debt ratio even further.820.275.] Sales per day = $7.000 – $616.

As a credit manager. suppliers could cut the company off. as a credit manager.2 million of new equity? Answer: While the firm’s ratios based on the projected data appear to be improving. and its bank could refuse to renew the loan when it comes due in 90 days. would you. also it was not maintaining financial ratios at levels called for in its bank loan agreements. Likewise. the firm’s current asset ratio is low. if you were the bank loan officer. particularly if my firm didn’t have any excess capacity. 26 Integrated Case Chapter 4: Analysis of Financial Statements . Terms of COD might be a little harsh and might push the firm into bankruptcy. continue to sell to D’Leon on credit? (You could demand cash on delivery—that is. On the basis of data provided.J. you would not continue to extend credit to the firm under its current arrangement. the company paid its suppliers much later than the due dates. sell on terms of COD—but that might cause D’Leon to stop buying from your company. Creditors’ actions would definitely be influenced by an infusion of equity capital in the firm. Therefore. would you recommend renewing the loan or demand its repayment? Would your actions be influenced if in early 2009 D’Leon showed you its 2009 projections along with proof that it was going to raise more than $1.) Similarly. This would lower the firm’s debt ratio and creditors’ risk exposure. In 2008. if the bank demanded repayment this could also force the firm into bankruptcy.

in a strong or weak position. L. it should have done an extensive ratio analysis to determine the effects of its proposed expansion on the firm’s operations. What are some potential problems and limitations of financial ratio analysis? Answer: [Show S4-33 and S4-34 here. “Average” performance is not necessarily good. the company would have “gotten its house in order” before undergoing the expansion. what should D’Leon have done back in 2007? Before the company took on its expansion plans.K. Seasonal factors can distort ratios. 8. 4. Had the ratio analysis been conducted. on balance. Comparison with industry averages is difficult if the firm operates many different divisions. Inflation has badly distorted many firms’ balance sheets. “Window dressing” techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons. 5.” Difficult to tell whether company is. 6. or a comparative Chapter 4: Analysis of Financial Statements Integrated Case 27 . Sometimes hard to tell if a ratio is “good” or “bad.] Some potential problems are listed below: 1. so a ratio analysis for one firm over time. Answer: In hindsight. 2. 7. 3.

28 Integrated Case Chapter 4: Analysis of Financial Statements . must be interpreted with judgment.analysis of firms of different ages.

are as follows: 1. 4. as summarized by the American Association of Individual Investors (AAII). Are changes in laws and regulations likely to have important implications for the firm? Chapter 4: Analysis of Financial Statements Integrated Case 29 . Are the company’s revenues tied to one key customer? To what extent are the company’s revenues tied to one key product? 3. 6.] Top analysts recognize that certain qualitative factors must be considered when evaluating a company. 2. How much competition does the firm face? Is it necessary for the company to continually invest in research and development? 7.M. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? Answer: [Show S4-35 here. These factors. To what extent does the company rely on a single supplier? What percentage of the company’s business is generated overseas? 5.

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