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3 LEARNING OBJECTIVES

LO 3-1 Ratio analysis provides a meaningful

Financial
comparison of a company to its industry.
LO 3-2 Ratios can be used to measure
profitability, asset utilization, liquidity,
and debt utilization.

Analysis LO 3-3 The Du Pont system of analysis identifies

the true sources of return on assets and
return to stockholders.
LO 3-4 Trend analysis shows company
performance over time.
LO 3-5 Reported income must be further
evaluated to identify sources of distortion.

I
f you’re in the market for dental products, look no further than Colgate-Palmolive. The
firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection,
whitening enhancement), as well as every shape and size of toothbrush. While you’re
getting ready for the day, also consider its soaps, shampoos, and deodorants (Speed
Stick, Lady Speed Stick, etc.).
For those of you who decide to stay home and clean your apartment or dorm room,
Colgate-Palmolive will provide you with Ajax, Fab, and a long list of other cleaning products.
All this is somewhat interesting, but why mention these subjects in a finance text? Well,
Colgate-Palmolive has had some interesting profit numbers over the last three years. Its
profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While
these numbers are higher than those of the average company, the 2014 number that
blows analysts away is its return on stockholders’ equity of 167.8 percent (the norm is
15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list
the number as not meaningful (NMF). The major reason for this abnormally high return is
its high debt-to-total-asset ratio of 81 percent. This means that the firm’s debt represents
81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of
profit will appear high in regard to the low value of stockholders’ equity.
In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on
stockholders’ equity, partially because it is heavily financed by stockholders’ equity at
66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This
kind of analysis will be found in the financial ratios discussion in this chapter.
In Chapter 2, we examined the basic assumptions of accounting and the various compo-
nents that make up the financial statements of the firm. We now use this fundamental mate-
rial as a springboard into financial analysis—to evaluate the financial performance of the firm.
The format for the chapter is twofold. In the first part we use financial ratios to evaluate
the relative success of the firm. Various measures such as net income to sales and current
assets to current liabilities will be computed for a hypothetical company and examined in
light of industry norms and past trends.
In the second part of the chapter we explore the impact of inflation and disinflation
on financial operations. You will begin to appreciate the impact of rising prices (or at

56

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Chapter 3 Financial Analysis 57

times, declining prices) on the various financial ratios. The chapter concludes with a
discussion of how other factors—in addition to price changes—may distort the financial
statements of the firm. Terms such as net income to sales, return on investment, and
inventory turnover take on much greater meaning when they are evaluated through the
eyes of a financial manager who does more than merely pick out the top or bottom line
of an income statement. The examples in the chapter are designed from the viewpoint
of a financial manager (with only minor attention to accounting theory).

Ratio Analysis
Ratios are used in much of our daily life. We buy cars based on miles per gallon; we
evaluate baseball players by earned run and batting averages, basketball players by
field goal and foul-shooting percentages, and so on. These are all ratios constructed to
judge comparative performance. Financial ratios serve a similar purpose, but you must
know what is being measured to construct a ratio and to understand the significance of
the resultant number.
Financial ratios are used to weigh and evaluate the operating performance of the
firm. While an absolute value such as earnings of $50,000 or accounts receivable of
$100,000 may appear satisfactory, its acceptability can be measured only in relation to
other values. For this reason, financial managers emphasize ratio analysis.
For example, are earnings of $50,000 actually good? If we earned $50,000 on
$500,000 of sales (10 percent “profit margin” ratio), that might be quite satisfactory—
whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent
return). After we have computed the appropriate ratio, we must compare our results
to those achieved by similar firms in our industry, as well as to our own performance
record. Even then, this “number-crunching” process is not fully adequate, and we are
forced to supplement our financial findings with an evaluation of company management,
physical facilities, corporate governance, sustainability, and numerous other factors.
Many libraries and universities subscribe to financial services such as Bloomberg,
Standard & Poor’s Industry Surveys and Corporate Reports, the Value Line Invest-
ment Survey, Factset, and Moody’s Corporation. Standard & Poor’s also leases a com-
puter database called S&P IQ to banks, corporations, investment organizations, and
universities. Compustat contains financial statement data on over 16,000 companies
for a 20-year period. Ratios can also be found on such websites as finance.yahoo.com.
These data can be used for countless ratios to measure corporate performance. The
ratios used in this text are a sample of the major ratio categories used in business, but
other classification systems can also be constructed.

Classification System
We will separate 13 significant ratios into four primary categories.
A. Profitability ratios
1. Profit margin
2. Return on assets (investment)
3. Return on equity

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58 Part 2 Financial Analysis and Planning

B. Asset utilization ratios

4. Receivable turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover
C. Liquidity ratios
9. Current ratio
10. Quick ratio
D. Debt utilization ratios
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
The first grouping, the profitability ratios, allows us to measure the ability of the
firm to earn an adequate return on sales, total assets, and invested capital. Many of the
problems related to profitability can be explained, in whole or in part, by the firm’s
ability to effectively employ its resources. Thus the next category is asset utilization
ratios. Under this heading, we measure the speed at which the firm is turning over
accounts receivable, inventory, and longer-term assets. In other words, asset utilization
ratios measure how many times per year a company sells its inventory or collects all of
its accounts receivable. For long-term assets, the utilization ratio tells us how produc-
tive the fixed assets are in terms of generating sales.
In category C, the liquidity ratios, the primary emphasis moves to the firm’s ability to
pay off short-term obligations as they come due. In category D, debt utilization ratios,
the overall debt position of the firm is evaluated in light of its asset base and earning power.
The users of financial statements will attach different degrees of importance to
the four categories of ratios. To the potential investor or security analyst, the critical
consideration is profitability, with secondary consideration given to such matters as
liquidity and debt utilization. For the banker or trade creditor, the emphasis shifts to
the firm’s current ability to meet debt obligations. The bondholder, in turn, may be
primarily influenced by debt to total assets—while also eyeing the profitability of the
firm in terms of its ability to cover debt obligations. Of course, the experienced analyst
looks at all the ratios, but with different degrees of attention.
Ratios are also important to people in the various functional areas of a business.
The marketing manager, the head of production, the human resource manager, and
many of their colleagues must all be familiar with ratio analysis. For example, the mar-
keting manager must keep a close eye on inventory turnover; the production manager
must evaluate the return on assets; and the human resource manager must look at the
effect of “fringe benefits” expenditures on the return on sales.

The Analysis
Definitions alone carry little meaning in analyzing or dissecting the financial per-
formance of a company. For this reason, we shall apply our four categories of ratios

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Chapter 3 Financial Analysis 59

to a hypothetical firm, the Saxton Company, as presented in Table  3-1. The use of
ratio analysis is rather like solving a mystery in which each clue leads to a new area
of inquiry.

Table 3-1 Financial statement for ratio analysis

SAXTON COMPANY
Income Statement
For the Year Ended December 31, 2015

Sales (all on credit) ........................................................................................... $4,000,000

Cost of goods sold ........................................................................................... 3,000,000
Gross profit ....................................................................................................... $1,000,000
Selling and administrative expense* ................................................................ 450,000
Operating profit ................................................................................................ $ 550,000
Interest expense ............................................................................................... 50,000
Extraordinary loss ............................................................................................. 200,000
Net income before taxes .................................................................................. $ 300,000
Taxes (33%) ...................................................................................................... 100,000
Net income ....................................................................................................... $ 200,000

*Includes $50,000 in lease payments.

Balance Sheet
As of December 31, 2015

Assets
Cash .................................................................................................................. $ 30,000
Marketable securities ........................................................................................ 50,000
Accounts receivable .......................................................................................... 350,000
Inventory ............................................................................................................ 370,000
Total current assets ........................................................................................ $ 800,000
Net plant and equipment ................................................................................... 800,000
Net assets ......................................................................................................... $1,600,000

Liabilities and Stockholders’ Equity

Accounts payable .............................................................................................. $ 50,000
Notes payable ................................................................................................... 250,000
Total current liabilities .................................................................................... $ 300,000
Long-term liabilities ........................................................................................... 300,000
Total liabilities ................................................................................................. $ 600,000
Common stock .................................................................................................. 400,000
Retained earnings ............................................................................................. 600,000
Total liabilities and stockholders’ equity ............................................................ $1,600,000

We first look at profitability ratios. The appropriate ratio

A. Profitability Ratios
is computed for the Saxton Company and is then compared to representative
industry data.

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60 Part 2 Financial Analysis and Planning

Saxton Company Industry Average

$200,000
1. Profit margin 5 ________
Net income ___________  5 5% 6.7%
Sales $4,000,000
2. Return on assets (investment) 5
Net income $200,000
a. ___________ ___________  5 12.5% 10%
Total assets $1,600,000
Net income Sales
b. ___________ 3 ___________ 5% 3 2.5 5 12.5% 6.7% 3 1.5 5 10%
Sales Total assets
3. Return on equity 5
Net income $200,000
a. ___________________ ___________ 5 20% 15%
Stockholders’ equity $1,000,000
Return on assets (investment) 0.125 0.10
b. ___________________________ _________ 5 20% ________  5 15%
(1 2 Debt/Assets) 1 2 0.375 1 2 0.33

In analyzing the profitability ratios, we see the Saxton Company shows a lower
return on the sales dollar (5 percent) than the industry average of 6.7 percent.
However, its return on assets (investment) of 12.5 percent exceeds the industry
norm of 10 percent. There is only one possible explanation for this occurrence—a
more rapid turnover of assets than that generally found within the industry. This is
verified in Ratio 2b, in which sales to total assets is 2.5 for the Saxton Company
and only 1.5 for the industry. Thus Saxton earns less on each sales dollar, but it
compensates by turning over its assets more rapidly (generating more sales per
dollar of assets).
Return on total assets as described through the two components of profit margin
and asset turnover is part of the Du Pont system of analysis.
Return on assets (investment) = Profit margin × Asset turnover
The Du Pont company was a forerunner in stressing that satisfactory return on
assets may be achieved through high profit margins or rapid turnover of assets, or a
combination of both. We shall also soon observe that under the Du Pont system of
analysis, the use of debt may be important. The Du Pont system causes the analyst to
examine the sources of a company’s profitability. Since the profit margin is an income
statement ratio, a high profit margin indicates good cost control, whereas a high asset
turnover ratio demonstrates efficient use of the assets on the balance sheet. Differ-
ent industries have different operating and financial structures. For example, in the
heavy capital goods industry the emphasis is on a high profit margin with a low asset
turnover—whereas in food processing, the profit margin is low and the key to satisfac-
tory returns on total assets is a rapid turnover of assets.
Equally important to a firm is its return on equity or ownership capital. For the
Saxton Company, return on equity is 20 percent, versus an industry norm of 15 per-
cent. Thus the owners of Saxton Company are more amply rewarded than are other
shareholders in the industry. This may be the result of one or two factors: a high return
on total assets or a generous utilization of debt or a combination thereof. This can be
seen through Ratio 3b, which represents a modified or second version of the Du Pont
formula.

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Chapter 3 Financial Analysis 61

Note that the numerator, return on assets, is taken from Ratio 2b, which represents
the initial version of the Du Pont formula (Return on assets  5  Net income/Sales 
3  Sales/Total assets). Return on assets is then divided by [1  2  (Debt/Assets)] to
account for the amount of debt in the capital structure. In the case of the Saxton Com-
pany, the modified version of the Du Pont formula shows:
Return on assets (investment)
Return on equity 5 ________________________
(1 2 Debt/Assets)
12.5%
5 ________  5 20%
1 2 0.375
Actually the return on assets of 12.5 percent in the numerator is higher than the
industry average of 10 percent, and the ratio of debt to assets in the denominator of
37.5 percent is higher than the industry norm of 33 percent. Please see Ratio 3b to
confirm these facts. Both the numerator and denominator contribute to a higher return
on equity than the industry average (20 percent versus 15 percent). Note that if the
firm had a 50 percent debt-to-assets ratio, return on equity would go up to 25 percent.1
Return on assets (investment)
Return on equity 5 ________________________
(1 2 Debt/Assets)
12.5%
5 _______  5 25%
1 2 0.50
This does not necessarily mean debt is a positive influence, only that it can be used to
boost return on equity. The ultimate goal for the firm is to achieve maximum valuation
for its securities in the marketplace, and this goal may or may not be advanced by using
debt to increase return on equity. Because debt represents increased risk, a lower valu-
ation of higher earnings is possible.2 Every situation must be evaluated individually.
You may wish to review Figure 3-1, which illustrates the key points in the Du Pont
system of analysis.

Figure 3-1 Du Pont analysis

Net income
Profit margin
Return on
Sales x
assets
Asset turnover

Total assets Return on assets Return on

(1 – Debt/Assets) =
equity
Total debt
Financing
plan
Total assets

1
The return could be slightly different than 25 percent because of changing financial costs with higher debt.
2
Further discussions of this point are presented in Chapter 5, “Operating and Financial Leverage,” and Chapter 10,
“Valuation and Rates of Return.”

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62 Part 2 Financial Analysis and Planning

As an example of the Du Pont analysis, Table  3-2 on the next page compares
two well-known retail store chains, Walmart and Abercrombie & Fitch. In 2014,
Abercrombie was more profitable in terms of profit margins (4.2 percent versus 3.3
percent). However, Walmart had a 19.5 percent return on equity versus 10.5 percent
for Abercrombie. Why the reversal in performance? It comes back to the Du Pont
system of analysis. Walmart turned over its assets 3.62 times a year versus a slower
2.15 times for Abercrombie.
Walmart was following the philosophy of its late founder Sam Walton: Give the cus-
tomer a bargain in terms of low prices (and low profit margins) but move the merchandise
quickly. Walmart was able to turn a low return on sales (profit margin) into a good return
on assets. Furthermore, its higher debt ratio (37.7 percent for Walmart versus 13.4 percent
for Abercrombie) allowed Walmart to turn its higher return on assets into an even higher
relative return on equity (19.5 percent versus 10.5 percent). For some firms, a higher debt
ratio might indicate additional risk, but for stable Walmart, this is not the case.
Finally, as a general statement in computing all the profitability ratios, the analyst
must be sensitive to the age of the assets. Plant and equipment purchased 15 years
ago may be carried on the books far below its replacement value in an inflationary
economy. A 20 percent return on assets purchased in the early 1990s may be inferior to
a 15 percent return on newly purchased assets.
B. Asset Utilization Ratios The second category of ratios relates to asset utilization,
and the ratios in this category may explain why one firm can turn over its assets more
rapidly than another. Notice that all of these ratios relate the balance sheet (assets)
to the income statement (sales). The Saxton Company’s rapid turnover of assets is
primarily explained in Ratios 4, 5, and 6.

Saxton Company Industry Average

4. Receivables turnover 5
Sales (credit)
____________ $4,000,000
___________  5 11.4 10 times
Receivables $350,000
5. Average collection period 5
Accounts receivable
_______________________ $350,000
_________ 5 32 36 days
Average daily credit sales $11,111
6. Inventory turnover 5
Sales
_________ $4,000,000
___________  5 10.8 7 times
Inventory $370,000
7. Fixed asset turnover 5
Sales
____________ $4,000,000
___________  5 5 5.4 times
Fixed assets $800,000
8. Total asset turnover 5
Sales
___________ $4,000,000
___________  5 2.5 1.5 times
Total assets $1,600,000

Saxton collects its receivables faster than does the industry. This is shown by the
receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by
the average collection period of 32 days, which is 4 days faster than the industry norm.

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Chapter 3 Financial Analysis 63

Table 3-2 Return on Equity: Walmart vs. Abercrombie & Fitch using the Du Pont Method of Analysis, 2014

A B A 3 B C D 5 (1 2 C) (A 3 B)/D

Profit Asset Return Debt/ 1 2 Debt/ Return on
Name Margin Turnover on Assets Assets Assets Equity

Walmart Stores Inc. 3.34% 3.63 12.1% 37.8% 62.2% 19.5%

Abercrombie & Fitch 4.24% 2.15 9.1% 13.4% 86.6% 10.5%

Data: December 31, 2014

The average collection period suggests how long, on average, customers’ accounts stay
on the books. The Saxton Company has $350,000 in accounts receivable and $4,000,000
in credit sales, which when divided by 360 days yields average daily credit sales of
$11,111. We divide accounts receivable of $350,000 by average daily credit sales
of $11,111 to determine how many days credit sales are on the books (32 days).
In addition, the firm turns over its inventory 10.8 times per year as contrasted with
an industry average of 7 times.3 This tells us that Saxton generates more sales per dol-
lar of inventory than the average company in the industry, and we can assume the firm
uses very efficient inventory-ordering and cost-control methods.
The firm maintains a slightly lower ratio of sales to fixed assets (plant and equip-
ment) than does the industry (5 versus 5.4) as shown above. This is a relatively minor
consideration in view of the rapid movement of inventory and accounts receivable.
Finally, the rapid turnover of total assets is again indicated (2.5 versus 1.5).

C. Liquidity Ratios After considering profitability and asset utilization, the analyst
needs to examine the liquidity of the firm. The Saxton Company’s liquidity ratios fare
well in comparison with the industry. Further analysis might call for a cash budget to
determine if the firm can meet each maturing obligation as it comes due.

Saxton Company Industry Average

9. Current ratio 5
Current assets
_______________ $800,000
_________ 5 2.67 2.1 times
Current liabilities $300,000
10. Quick ratio 5
Current assets 2 Inventory
_________________________ $430,000
_________ 5 1.43 1.0 times
Current liabilities $300,000

D. Debt Utilization Ratios The last grouping of ratios, debt utilization, allows the
analyst to measure the prudence of the debt management policies of the firm.

3
This ratio may also be computed by using “Cost of goods sold” in the numerator. While this offers some theoreti-
cal advantages in terms of using cost figures in both the numerator and denominator, Dun & Bradstreet and other
credit reporting agencies generally show turnover using sales in the numerator.

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64 Part 2 Financial Analysis and Planning

Debt to total assets of 37.5 percent as shown in Ratio 11 is slightly above the
industry average of 33 percent, but well within the prudent range of 50 percent or less.4

Saxton Company Industry Average

11. Debt to total assets 5
Total debt
___________ $600,000
___________  5 37.5% 33%
Total assets $1,600,000
12. Times interest earned 5
Income before interest and taxes
______________________________ $550,000
_________ 5 11 7 times
Interest $50,000
13. Fixed charge coverage 5
Income before fixed charges and taxes
___________________________________ $600,000
_________ 5 6 5.5 times
Fixed charges $100,000

Ratios for times interest earned and fixed charge coverage show that the Saxton
Company debt is being well managed compared to the debt management of other
firms in the industry. Times interest earned indicates the number of times that income
before interest and taxes covers the interest obligation (11 times). The higher the ratio,
the stronger is the interest-paying ability of the firm. The figure for income before
interest and taxes ($550,000) in the ratio is the equivalent of the operating profit figure
presented in the upper part of Table 3-1.
Fixed charge coverage measures the firm’s ability to meet all fixed obligations
rather than interest payments alone, on the assumption that failure to meet any
financial obligation will endanger the position of the firm. In the present case, the
Saxton Company has lease obligations of $50,000 as well as the $50,000 in interest
expenses. Thus the total fixed charge financial obligation is $100,000. We also need
to know the income before all fixed charge obligations. In this case, we take income
before interest and taxes (operating profit) and add back the $50,000 in lease
payments.

Income before interest and taxes ............................................... $550,000

Lease payments ......................................................................... 50,000
Income before fixed charges and taxes ..................................... $600,000

The fixed charges are safely covered 6 times, exceeding the industry norm of
5.5 times. The various ratios are summarized in Table 3-3. The conclusions reached
in comparing the Saxton Company to industry averages are generally valid, though
exceptions may exist. For example, a high inventory turnover is considered “good”
unless it is achieved by maintaining unusually low inventory levels, which may hurt
future sales and profitability.

4
From the Du Pont system of analysis discussed earlier in the chapter, we used total debt to total assets. There are
also other important debt measures used for different purposes, such as long-term debt to equity.

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Chapter 3 Financial Analysis 65

Table 3-3 Ratio analysis

Saxton Industry
Conclusion
Company Average
A. Profitability
1. Profit margin .......................... 5.0% 6.7% Below average
2. Return on assets ................... 12.5% 10.0% Above average due to high turnover
3. Return on equity ................... 20.0% 15.0% Good, due to Ratios 2 and 11
B. Asset Utilization
4. Receivables turnover ............ 11.4 10.0 Good
5. Average collection period ......... 32.0 36.0 Good
6. Inventory turnover ................. 10.8 7.0 Good
7. Fixed asset turnover ............. 5.0 5.4 Below average
8. Total asset turnover .............. 2.5 1.5 Good
C. Liquidity
9. Current ratio .......................... 2.67 2.1 Good
10. Quick ratio ............................ 1.43 1.0 Good
D. Debt Utilization
11. Debt to total assets .............. 37.5% 33.0% Slightly more debt
12. Times interest earned ........... 11.0 7.0 Good
13. Fixed charge coverage ......... 6.0 5.5 Good

In summary, the Saxton Company more than compensates for a lower return on the
sales dollar by a rapid turnover of assets, principally inventory and receivables, and a
wise use of debt. You should be able to use these 13 measures to evaluate the financial
performance of any firm.

Trend Analysis
Over the course of the business cycle, sales and profitability may expand and contract,
and ratio analysis for any one year may not present an accurate picture of the firm. There-
fore we look at the trend analysis of performance over a number of years. However,
without industry comparisons even trend analysis may not present a complete picture.
For example, in Figure 3-2 on the next page, we see that the profit margin for the
Saxton Company has improved, while asset turnover has declined. This by itself may
look good for the profit margin and bad for asset turnover. However, when compared
to industry trends, we see the firm’s profit margin is still below the industry average.
With asset turnover, Saxton has improved in relation to the industry even though it is
in a downward trend. Similar data could be generated for the other ratios.
By comparing companies in the same industry, the analyst can examine and compare
trends over time. In looking at the computer industry data in Table 3-4 on page 67, it is
apparent that profit margins and returns on equity have changed over time for IBM and
Apple. This is primarily due to intensified competition within the industry. IBM began to
feel the squeeze on profits first, beginning in 1991, and actually lost money in 1993. By
1994, Lou Gerstner took over as chairman and chief executive officer at IBM and began

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66 Part 2 Financial Analysis and Planning

Figure 3-2 Trend analysis

A. Profit margin

Percent

Industry
7
Saxton
5

2003 2005 2007 2009 2011 2013 2015

B. Total asset turnover

3.5X
3.0X
2.5X
Saxton
2.0X
1.5X
1.0X Industry
0.5X

2003 2005 2007 2009 2011 2013 2015

turning the company around; by 1997, IBM was back to its old levels of profitability and
hitting all-time highs for return on stockholders’ equity. This continued until the reces-
sion of 2001–2002. During the next decade, IBM engaged in financial engineering. It
kept repurchasing shares of stock in the market, reducing its share count from 29.7 bil-
lion shares in 2004 to 17.2 billion shares in 2014. During the same years, its revenues
decreased from $96.3 billion to $94.5 billion.
In 2003, Apple Computer began its amazing run over the next 10 years, creating the
iPod, annual versions of the iPhone, the iPad, and iPad mini, and new versions of its
MacBook and iMac computers. Note that even though Apple’s profit margin far exceeds
that of IBM, IBM still has a higher return on equity. This takes us back to the Du Pont
model. IBM has a debt-to-asset ratio of 72.5 percent in its capital structure while Apple
has a 24 percent debt-to-asset ratio. In addition, IBM has been buying back billions of dol-
lars of stock in the market over the last 10 years and has reduced stockholders’ equity on its
balance sheet. Both the debt and stock repurchases have inflated IBM’s return on equity.
Apple was debt free until 2013 when, under pressure from institutional stockhold-
ers, the company agreed to sell a total of $35.3 billion of debt and use the proceeds to
raise its dividends as well as buy back some stock. In contrasting the two companies,
we should point out that while IBM’s revenues were stagnant from 2004 to 2014,
Apple grew its revenues from $8.2 billion in 2004 to $182.795 billion, almost dou-
bling IBM’s revenues of $94.5 billion.

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Chapter 3 Financial Analysis 67

Table 3-4 Trend analysis in the computer industry

IBM Apple
Profit Return on Profit Return on
Margin Equity Margin Equity

1988 9.7 14.9 9.8 43.5

1989 6.0 9.6 8.6 36.5
1990 8.7 14.8 8.5 32.4
1991 24.4 27.2 4.9 19.3
1992 27.7 215.4 7.5 26.8
1993 212.9 235.2 1.1 4.1
1994 4.7 14.3 3.4 14.1
1995 5.8 18.5 3.8 16.0
1996 7.1 24.8 28.3 232.9
1997 7.8 29.7 214.8 267.2
1998 7.7 32.6 5.2 24.3
1999 8.8 39.0 9.8 27.0
2000 9.2 39.7 9.8 22.5
2001 9.3 35.2 20.5 20.6
2002 4.4 15.5 1.1 1.6
2003 8.5 29.9 1.1 1.7
2004 7.8 25.1 3.3 5.9
2005 8.7 24.5 9.5 21.2
2006 10.4 30.8 10.3 22.8
2007 10.5 36.6 14.2 28.5
2008 11.9 58.8 16.3 33.2
2009 14.0 74.4 19.2 30.5
2010 14.9 64.9 21.5 35.3
2011 14.8 73.4 23.9 41.7
2012 15.9 88.0 26.7 35.3
2013 16.5 72.3 21.7 30.0
2014 16.0 87.0 21.6 35.4

What will be the trends for these two companies for the rest of the decade? Tech-
nology is changing so quickly that no one can say. Both are likely to remain lean in
operating expenses but highly innovative in new product development.

Impact of Inflation on Financial Analysis

Before, coincident with, or following the computation of financial ratios, we should
explore the impact of inflation and other sources of distortion on the financial report-
ing of the firm. As illustrated in this section, inflation causes phantom sources of
profit that may mislead even the most alert analyst. Disinflation also causes certain
problems, and we shall consider these as well.
The major problem during inflationary times is that revenue is almost always stated
in current dollars, whereas plant and equipment or inventory may have been purchased
at lower price levels. Thus profit may be more a function of increasing prices than of

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Finance in Are Financial Analysts Friends or Foes to Investors?

ACTION Reader Beware!

Managerial Financial analysis is done not only by manag-

ers of the firm but by outside analysts as well.
policy for analysts never to make negative
comments about firms providing investment
These outside analysts normally supply data banking fees. Pity the poor investor who
to stock market investors. naively followed the advice of Morgan Stanley
One of the problems that was detected during the mid-1990s.
after the great bull market of the 1990s was After the market crash of the early 2000s,
that analysts were not always as objective the SEC and federal legislators began requir-
as they should be. This unfortunate discov- ing investment bankers to either fully separate
ery helped intensify the bear market of the their financial analysis and underwriting busi-
early 2000s. ness or, at a minimum, fully divulge any such
The reason that many analysts lack objec- relationships. For example, Merrill Lynch now
tivity is that they work for investment banking– states in its research reports, “Investors should
brokerage firms that not only provide financial assume that Merrill Lynch is seeking or will
analysis for investors, but also underwrite seek investing banking or other business rela-
the securities of the firms they are covering. tionships with the companies in this report.”
Underwriting activity involves the distribution The government is also requiring investment
of new securities in the public markets and bankers to provide independent reports to
is highly profitable to the investment banker. accompany their own in-house reports. These
For example, Goldman Sachs, a major Wall independent reports are done by fee-based
Street investment banking firm, may not only research firms that do not engage in under-
be doing research and financial analysis on writing activities. Independent firms include
General Electric or Eastman Kodak, but also Standard & Poor’s, Value Line, Morningstar,
profiting from investment banking business and other smaller firms. They tend to be totally
with these firms. objective and hard-hitting when necessary.
Since the fees from investment bank- Some independent research firms know
ing activities contribute heavily to the overall more about a company than it knows
operations of the investment banker, many about itself. Take the example of Sanford
analysts for investment banking firms “relaxed C. Bernstein & Co. and Cisco Systems in late
their standards” in doing financial analysis on 2000. Bernstein analyst Paul Sagawa down-
their clients in the 1990s. graded Cisco for investment purposes even
As an example, Goldman Sachs, Merrill though Cisco Chief Executive Officer John
Lynch, and other Wall Street firms often failed T. Chambers respectfully disagreed. The
to divulge potential weaknesses in the firms astute independent analyst anticipated the
they were investigating for fear of losing the end of the telecom boom and knew the disas-
clients’ investment banking business. Corpo- trous effect it would have on Cisco because
rations that were being reported upon were the company would lose key telecom custom-
www. equally guilty. Many a corporate chief officer ers. When the disaster finally occurred, CEO
told an investment banker that “if you come Chambers told investors that “No one could
goldmansachs.com
out with a negative report, you will never see have predicted it. It was like a 100-year flood.”
www.ml.com another dollar’s worth of our investment bank- Apparently he forgot about the Sagawa report
ing business.” Morgan Stanley, a major invest- he had read and dismissed only a few months
ment banker, actually had a written internal before.

satisfactory performance. Although inflation has been moderate since the early 1990s,
it tends to reappear so you should be aware of its consequences. One of the major
concerns of many economists is that the United States will suffer from an inflationary
spiral before 2020 because of all the money that the Federal Reserve has pumped into
the economy to help pull the country out of its financial crisis. So far there is no sign
of rising inflation, but it pays to be vigilant.
68

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Chapter 3 Financial Analysis 69

An Illustration
The Stein Corporation shows the accompanying income statement for 2015 in
Table 3-5. At year-end the firm also has 100 units still in inventory at $1 per unit.

Table 3-5 Stein Corporation Income Statement for 2015

STEIN CORPORATION
Net Income for 2015

Sales ................................................................................. $200 (100 units at $2)

Cost of goods sold ........................................................... 100 (100 units at $1)
Gross profit ....................................................................... $100
Selling and administrative expense .................................. 20 (10% of sales)
Depreciation ..................................................................... 10
Operating profit ................................................................ $ 70
Taxes (40%) ...................................................................... 28
Aftertax income ................................................................ $ 42

Assume that in the year 2016 the number of units sold remains constant at 100.
However, inflation causes a 10 percent increase in price, from $2 to $2.20. Total sales
will go up to $220 as shown in Table  3-6, but with no actual increase in physical
volume. Further, assume the firm uses FIFO inventory pricing, so that inventory first
purchased will be written off against current sales. In this case, 2015 inventory will be
written off against year 2016 sales revenue.
In Table 3-6, the company appears to have increased profit by $11 compared to that
shown in Table 3-5 (from $42 to $53) simply as a result of inflation. But not reflected
is the increased cost of replacing inventory and plant and equipment. Presumably,
replacement costs have increased in an inflationary environment.

Table 3-6 Stein Corporation Income Statement for 2016

STEIN CORPORATION
Net Income for 2016
Sales ............................................................. $220 (100 units at 2000 price of $2.20)
Cost of goods sold ....................................... 100 (100 units at $1.00)
Gross profit ................................................... $120
Selling and administrative expense .............. 22 (10% of sales)
Depreciation ................................................. 10
Operating profit ............................................ $ 88
Taxes (40%) .................................................. 35
Aftertax income ............................................ $ 53

As mentioned in Chapter 2, inflation-related information was formerly required by

the FASB for large companies, but this is no longer the case. It is now purely volun-
tary. What are the implications of this type of inflation-adjusted data? From a study
of 10 chemical firms and eight drug companies, using current cost (replacement cost)

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70 Part 2 Financial Analysis and Planning

data found in the financial 10K statements these companies filed with the Securities
and Exchange Commission, it was found that the changes shown in Table 3-7 occurred
in their assets, income, and selected ratios.5

Table 3-7 Comparison of replacement cost accounting and historical cost accounting

10 Chemical Companies 8 Drug Companies

Replacement Historical Replacement Historical
Cost Cost Cost Cost
Increase in assets .................... 28.4% — 15.4% —
Decrease in net income
before taxes ......................... 45.8% — 19.3% —
Return on assets ...................... 2.8% 6.2% 8.3% 11.4%
Return on equity ...................... 4.9% 13.5% 12.8% 19.6%
Debt-to-assets ratio ................. 34.3% 43.8% 30.3% 35.2%
Interest coverage ratio
(times interest earned) .......... 7.1 times  8.4 times  15.4 times  16.7 times 

The comparison of replacement cost and historical cost accounting methods in the
table shows that replacement cost reduces income but at the same time increases assets.
This increase in assets lowers the debt-to-assets ratio since debt is a monetary asset that
is not revalued because it is paid back in current dollars. The decreased debt-to-assets
ratio would indicate the financial leverage of the firm is decreased, but a look at the
interest coverage ratio tells a different story. Because the interest coverage ratio mea-
sures the operating income available to cover interest expense, the declining income
penalizes this ratio and the firm has decreased its ability to cover its interest cost.

Disinflation Effect
As long as prices continue to rise in an inflationary environment, profits appear to feed
on themselves. The main problem is that when price increases moderate (disinflation),
there will be a rude awakening for management and unsuspecting stockholders as
expensive inventory is charged against softening retail prices. A 15 or 20 percent
growth rate in earnings may be little more than an “inflationary illusion.” Industries
most sensitive to inflation-induced profits are those with cyclical products, such as
lumber, copper, rubber, and food products, and also those in which inventory is a sig-
nificant percentage of sales and profits.
A leveling off of prices is not necessarily bad. Even though inflation-induced cor-
porate profits may be going down, investors may be more willing to place their funds
in financial assets such as stocks and bonds. The reason for the shift may be a belief
that declining inflationary pressures will no longer seriously impair the purchas-
ing power of the dollar. Lessening inflation means the required return that investors
demand on financial assets will be going down, and with this lower demanded return,
future earnings or interest should receive a higher current valuation.
5
Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study of the Chemical and Drug Industry for
Years 1976 through 1978.” Replacement cost is but one form of current cost. Nevertheless, it is often used as a
measure of current cost.

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Chapter 3 Financial Analysis 71

None of this happens with a high degree of certainty. To the extent that investors ques-
tion the permanence of disinflation (leveling off of price increases), they may not act
according to the script. That is, lower rates of inflation will not necessarily produce high
stock and bond prices unless reduced inflation is sustainable over a reasonable period.
Whereas financial assets such as stocks and bonds have the potential (whether real-
ized or not) to do well during disinflation, such is not the case for tangible (real) assets.
Precious metals, such as gold and silver, gems, and collectibles, that boomed in the
highly inflationary environment of the late 1970s fell off sharply a decade later, as
softening prices caused less perceived need to hold real assets as a hedge against infla-
tion. The shifting back and forth by investors between financial and real assets may
occur many times over a business cycle.

Deflation There is also the danger of deflation, actual declining prices in which
everyone gets hurt from bankruptcies and declining profits. This happened in Russia,
Asia, and other foreign countries in 1998, and it has become a worry in Russia and
Europe in 2015. One of the negative consequences is that debt has to be repaid with
more expensive currency rather than with cheaper money under inflationary condi-
tions. The same phenomenon happened in the United States from 2007 to 2009 and is
a continuing concern of the Federal Reserve Board. Monetary authorities would rather
have a low-inflation economy than a deflationary economy.

Other Elements of Distortion in Reported Income

The effect of changing prices is but one of a number of problems the analyst must cope
with in evaluating a company. Other issues, such as the reporting of revenue, the treat-
ment of nonrecurring items, and the tax write-off policy, cause dilemmas for the finan-
cial manager or analyst. We can illustrate this point by considering the income statements
for two hypothetical companies in the same industry as shown in Table 3-8 on the next
page. Both firms had identical operating performances for 2015—but Company A is
very conservative in reporting its results, while Company B has attempted to maximize
its reported income.
If both companies had reported income of $280,000 in the prior year of 2014, Com-
pany B would be thought to be showing substantial growth in 2015 with net income of
$700,000, while Company A is reporting a “flat” or no-growth year in 2015. However,
we have already established that the companies have equal operating performances.

Explanation of Discrepancies
Let us examine how the inconsistencies in Table 3-8 could occur. Emphasis is given to
a number of key elements on the income statement. The items being discussed here are
not illegal but reflect flexibility in financial reporting.

Sales Company B reported $200,000 more in sales, although actual volume was the
same. This may be the result of different concepts of revenue recognition.
For example, certain assets may be sold on an installment basis over a long period.
A conservative firm may defer recognition of the sales or revenue until each pay-
ment is received, while other firms may attempt to recognize a fully effected sale at

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72 Part 2 Financial Analysis and Planning

Table 3-8

INCOME STATEMENTS
For the Year 2015

Conservative High Reported

Firm A Income
Firm B
Sales ................................................................................. $4,000,000 $4,200,000
Cost of goods sold ........................................................... 3,000,000 2,700,000
Gross profit ....................................................................... $1,000,000 $1,500,000
Selling and administrative expense .................................. 450,000 450,000
Operating profit ................................................................ $ 550,000 $1,050,000
Interest expense ............................................................... 50,000 50,000
Extraordinary loss ............................................................. 100,000 —
Net income before taxes .................................................. $ 400,000 $1,000,000
Taxes (30%) ...................................................................... 120,000 300,000
Net income ....................................................................... $ 280,000 $ 700,000
Extraordinary loss (net of tax) ........................................... — 70,000
Net income transferred to retained earnings .................... $ 280,000 $ 630,000

the earliest possible date. Similarly, firms that lease assets may attempt to consider a
long-term lease as the equivalent of a sale, while more conservative firms recognize as
revenue each lease payment only when it comes due. Although the accounting profes-
sion attempts to establish appropriate methods of financial reporting through generally
accepted accounting principles, reporting varies among firms and industries.

Cost of Goods Sold The conservative firm (Company A) may well be using LIFO
accounting in an inflationary environment, thus charging the last-purchased, more expen-
sive items against sales, while Company B uses FIFO accounting—charging off less
expensive inventory against sales. The $300,000 difference in cost of goods sold may also
be explained by varying treatment of research and development costs and other items.

Extraordinary Gains/Losses Nonrecurring gains or losses may occur from the sale of
corporate fixed assets, lawsuits, or similar nonrecurring events. Some analysts argue
that such extraordinary events should be included in computing the current income
of the firm, while others would leave them off in assessing operating performance.
Unfortunately, nonrecurring losses are treated inconsistently despite attempts by
the accounting profession to ensure uniformity. The conservative Firm A has writ-
ten off its $100,000 extraordinary loss against normally reported income, while Firm
B carries a subtraction against net income only after the $700,000 amount has been
reported. Both had similar losses of $100,000, but Firm B’s loss is shown net of tax
implications at $70,000.
Extraordinary gains and losses happen among large companies more often than
you might think. General Motors has had “nonrecurring” losses four times in the last
decade. This, in part, led to its decline as a major corporation. In the current age of

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Finance in
Sustainability, ROA, and the “Golden Rule” ACTION
Perhaps “sustainability” isn’t the first word
that comes to mind when someone thinks
today an infrastructure has developed to recy-
cle more waste at lower costs.
Ethics
about the garbage business. However, today’s Based purely on a short-run ROA, the
waste industry leaders not only develop sani- firm’s long-term commitment was not justi-
tary landfills with synthetic liners and ground fied, but Poole’s commitment to recycling
water monitoring wells, but they are often and other sustainable practices were part of
at the forefront of community recycling and a wider corporate culture focused on treating
renewable energy efforts. customers, employees, and the broader com-
When Lonnie Poole started Waste Indus- munity with respect.
tries in 1970, he didn’t know that the company Now business researchers are finding that
would grow to be one of the country’s larg- Poole may have simply been ahead of his
est waste companies, but like most entre- time. When Harvard researchers examined the
preneurs, he did believe that he could build impact of corporate sustainability initiatives
a business for the long haul. Focused on a on long-term firm performance, they discov-
commitment to service, Poole knew that his ered both higher ROA and higher ROE (return
company had to find ways to offer service on equity) for firms whose executives pro-
options that were both economically viable moted sustainability within their firms.
and environmentally sustainable. Sometimes Philosophers and religious leaders have
projects provided an adequate near-term long touted the “golden rule” as a basic
return on assets (ROA), and they also made ethical code, which states one should do
sense from a sustainability perspective. Other to others what they would wish done to
times, doing the right thing from a long-term themselves. Like many successful business
sustainability perspective meant Waste Indus- people, Poole believed sustainability meant
tries needed to find a way to overcome short- making a positive difference in the com-
term financial considerations. munities his company served, enriching the
Take the company’s recycling effort as an lives of employees, and forging meaningful
example. Waste Industries has been engaged relationships with vendors and suppliers. In
in recycling since the 1970s. From an ROA the long run, these values paid off. Perhaps
perspective, it was hard to justify the firm’s this is why a basic rule for ethical behavior is
recycling efforts. At first, there was no market called “golden.”
for the recyclables. Instead of selling recycled
paper, the firm had to pay paper companies to Source: R.G. Eccles, I. Ioannou, and G. Serafeim,
haul recycled paper away. Over time, Waste “The Impact of a Corporate Culture of Sustainabil-
Industries’ investments in sustainability began ity on Corporate Behavior and Performance,” NBER
to pay off. Due to their early investments, Working Paper No. 17950, 2012.

mergers, tender offers, and buyouts, understanding the finer points of extraordinary
gains and losses becomes even more important.

Net Income
Firm A has reported net income of $280,000, while Firm B claims $700,000 before
subtraction of extraordinary losses. The $420,000 difference is attributed to differ-
ent methods of financial reporting, and it should be recognized as such by the ana-
lyst. No superior performance has actually taken place. The analyst must remain
ever alert in examining each item in the financial statements, rather than accepting
bottom-line figures.
73

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74 Part 2 Financial Analysis and Planning

SUMMARY
Ratio analysis allows the analyst to compare a company’s performance to that of others
in its industry. Ratios that initially appear good or bad may not retain that characteris-
tic when measured against industry peers.
There are four main groupings of ratios. Profitability ratios measure the firm’s abil-
ity to earn an adequate return on sales, assets, and stockholders’ equity. The asset
utilization ratios tell the analyst how quickly the firm is turning over its accounts
receivable, inventory, and longer-term assets. Liquidity ratios measure the firm’s abil-
ity to pay off short-term obligations as they come due, and debt utilization ratios indi-
cate the overall debt position of the firm in light of its asset base and earning power.
The Du Pont system of analysis first breaks down return on assets between the profit
margin and asset turnover. The second step shows how this return on assets is translated
into return on equity through the amount of debt the firm has. Throughout the analysis,
the analyst can better understand how return on assets and return on equity are derived.
Over the course of the business cycle, sales and profitability may expand and con-
tract, and ratio analysis for any one year may not present an accurate picture of the
firm. Therefore we look at the trend analysis of performance over a period of years.
A number of factors may distort the numbers accountants actually report. These
include the effect of inflation or disinflation, the timing of the recognition of sales as
revenue, the treatment of inventory write-offs, the presence of extraordinary gains and
losses, and so on. The well-trained financial analyst must be alert to all of these factors.

LIST OF TERMS
profitability ratios 58 debt utilization ratios 58
profit margin debt to total assets
return on asset times interest earned
return on equity fixed charge coverage
asset utilization ratios 58 Du Pont system of analysis 60
receivable turnover trend analysis 65
average collection period inflation 67
inventory turnover replacement costs 69
fixed asset turnover disinflation 70
total asset turnover deflation 71
liquidity ratios 58 LIFO 72
current ratio FIFO 72
quick ratio

DISCUSSION QUESTIONS
1. If we divide users of ratios into short-term lenders, long-term lenders, and
stockholders, which ratios would each group be most interested in, and for
what reasons? (LO3-2)
2. Explain how the Du Pont system of analysis breaks down return on assets. Also
explain how it breaks down return on stockholders’ equity. (LO3-3)
3. If the accounts receivable turnover ratio is decreasing, what will be happening
to the average collection period? (LO3-2)
4. What advantage does the fixed charge coverage ratio offer over simply using
times interest earned? (LO3-2)

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Chapter 3 Financial Analysis 75

5. Is there any validity in rule-of-thumb ratios for all corporations, such as

a current ratio of 2 to 1 or debt to assets of 50 percent? (LO3-2)
6. Why is trend analysis helpful in analyzing ratios? (LO3-4)
7. Inflation can have significant effects on income statements and balance sheets,
and therefore on the calculation of ratios. Discuss the possible impact of infla-
tion on the following ratios, and explain the direction of the impact based on
your assumptions. (LO3-5)
a. Return on investment
b. Inventory turnover
c. Fixed asset turnover
d. Debt-to-assets ratio
8. What effect will disinflation following a highly inflationary period have on the
reported income of the firm? (LO3-5)
9. Why might disinflation prove favorable to financial assets? (LO3-5)
10. Comparisons of income can be very difficult for two companies even though
they sell the same products in equal volume. Why? (LO3-2)

PRACTICE PROBLEMS AND SOLUTIONS Profitability ratios

(LO3-2)
1. Barnes Appliances has sales of $10,000,000, net income of $450,000, total assets
of $4,000,000, and stockholders’ equity of $2,000,000.
a. What is the profit margin?
b. What is the return on assets?
c. What is the return on equity?
d. The debt-to-assets ratio is currently 50 percent. If it were 60 percent, what would
the return on equity be? To answer this question, use Ratio 3b in the text.
2. The Gilliam Corp. has the following balance sheet and income statement. All 13 ratios
Compute the profitability, asset utilization, liquidity, and debt utilization ratios. (LO3-2)

GILLIAM CORPORATION
Balance Sheet
December 31, 20X1

Assets
Current assets:
Cash ................................................................................................................... $ 70,000
Marketable securities ......................................................................................... 40,000
Accounts receivable (net) ................................................................................... 250,000
Inventory ............................................................................................................ 200,000
Total current assets ........................................................................................ $ 560,000
Investments ........................................................................................................... 100,000
Net plant and equipment ................................................................................... 440,000
Total assets ............................................................................................................ $1,100,000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable .............................................................................................. $ 130,000
Notes payable .................................................................................................... 120,000
Accrued taxes .................................................................................................... 30,000
Total current liabilities ..................................................................................... $ 280,000
(continued)

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76 Part 2 Financial Analysis and Planning

(continued)

GILLIAM CORPORATION
Balance Sheet
December 31, 20X1

Long-term liabilities:
Bonds payable ................................................................................................... $ 200,000
Total liabilities ..................................................................................................... $ 480,000
Stockholders’ equity
Preferred stock, $100 par value ............................................................................ $ 150,000
Common stock, $5 par value ............................................................................. 50,000
Capital paid in excess of par ............................................................................. 200,000
Retained earnings .............................................................................................. 220,000
Total stockholders’ equity .............................................................................. $ 620,000
Total liabilities and stockholders’ equity ................................................................ $1,100,000

GILLIAM CORPORATION
Income Statement
For the Year Ending December 31, 20X1

Sales (on credit) ..................................................................................................... $2,400,000

Less: Cost of goods sold ................................................................................... 1,600,000
Gross profit ............................................................................................................ $ 800,000
Less: Selling and administrative expenses ........................................................ 560,000*
Operating profit (EBIT) ........................................................................................... $ 240,000
Less: Interest expense ....................................................................................... 30,000
Earnings before taxes (EBT) .................................................................................. $ 210,000
Less: Taxes ........................................................................................................ 75,000
Earnings after taxes (EAT) ..................................................................................... $ 135,000

*Includes $40,000 in lease payments.

Solutions
$450,000
Net income 5 ___________
1. a. Profit margin 5 __________ 5 4.5%
Sales $10,000,000
$450,000
Net income 5 __________
b. Return on assets 5 __________ 5 11.25%
Total assets $4,000,000
Net income $450,000
c. Return on equity 5 _________________ 5 __________ 5 22.5%
Stockholders’ equity $2,000,000
Return on assets (investment) 11.25%
d. Return on equity 5 ________________________ 5 ________
(1 2 Debt/Assets) (1 2 0.6)
11.25% 5 28.13%
5 _______
0.4
2. Profitability ratios
$135,000
Net income 5 _________
1. Profit margin 5 __________ 5 5.63%
Sales 2,400,000

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Chapter 3 Financial Analysis 77

$135,000
Net income 5 _________
2. Return on assets 5 __________ 5 12.27%
Total assets 1,100,000
Net income $135,000
3. Return on equity 5 _________________ 5 ________ 5 21.77%
Stockholders’ equity 620,000

Asset utilization ratios

$2,400,000
Sales (credits) 5 __________
4. Receivables turnover 5 _________________ 5 9.6 times
Accounts receivable 250,000
$250,000
Accounts receivable 5 ________
5. Average collection period 5 __________________  5 37.5 days
Avg. daily credit sales 6,667
$2,400,000
Sales 5 __________
6. Inventory turnover 5 ________ 5 12 times
Inventory 200,000
Sales $2,400,000
7. Fixed asset turnover 5 __________ 5 __________ 5 5.45 times
Fixed assets 440,000
Sales $2,400,000
8. Total asset turnover 5 __________ 5 __________ 5 2.18 times
Total assets 1,100,000

Liquidity ratios
$560,000
Current assets 5 ________
9. Current ratio 5 _______________ 5 2 times
Current liabilities 280,000
Current assets 2 Inventory $560,000 2 200,000
10. Quick ratio 5 ______________________ 5 _________________
Current liabilities 280,000
360,000
5 _______ 5 1.29 times
280,000

Debt utilization ratios

$480,000
Total debt 5 _________
11. Debt to total assets 5 __________ 5 43.64%
Total assets 1,100,000
Income before interest and taxes
12. Times interest earned 5 ___________________________
Interest

Note: Income before interest and taxes equals operating profit, $240,000.

240,000
Times interest earned 5 _______ 5 8 times
30,000
Income before fixed charges and taxes
13. Fixed charge coverage 5 _______________________________
Fixed charges

Income before fixed charges and taxes 5 Operating profit 1 Lease

payments*
$240,000 1 $40,000 5 $280,000

*Lease payments are in a footnote on the income statement (middle of page 64).

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78 Part 2 Financial Analysis and Planning

Fixed charges 5 Lease payments 5 Interest

$40,000 1 $30,000 5 $70,000
$280,000
Fixed charge coverage 5 ________ 5 4 times
70,000

PROBLEMS
Selected problems are available with Connect. Please see the preface for more information.

Basic Problems
Profitability ratios 1. Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of
(LO3-2) $156,000 on sales of $2,010,000. Division B is able to make only $28,800 on
sales of $329,000. Based on the profit margins (returns on sales), which division
is superior?
Profitability ratios 2. Database Systems is considering expansion into a new product line. Assets to
(LO3-2) support expansion will cost $380,000. It is estimated that Database can gener-
ate $1,410,000 in annual sales, with an 8 percent profit margin. What would net
income and return on assets (investment) be for the year?
Profitability ratios 3. Polly Esther Dress Shops Inc. can open a new store that will do an annual sales
(LO3-2) volume of $837,900. It will turn over its assets 1.9 times per year. The profit
margin on sales will be 8 percent. What would net income and return on assets
(investment) be for the year?
Profitability ratios 4. Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns over its assets
(LO3-2) 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit margin
(return on sales)?
Profitability ratios 5. Elizabeth Tailors Inc. has assets of $8,940,000 and turns over its assets 1.9 times
(LO3-2) per year. Return on assets is 13.5 percent. What is the firm’s profit margin
(returns on sales)?
Profitability ratios 6. Dr. Zhivàgo Diagnostics Corp.’s income statement for 20X1 is as follows:
(LO3-2)
Sales .................................................................................................... $2,790,000
Cost of goods sold .............................................................................. 1,790,000
Gross profit .......................................................................................... $1,000,000
Selling and administrative expense ..................................................... 302,000
Operating profit ................................................................................... $ 698,000
Interest expense .................................................................................. 54,800
Income before taxes ............................................................................ $ 643,200
Taxes (30%) ......................................................................................... 192,960
Income after taxes ............................................................................... $ 450,240

a. Compute the profit margin for 20X1.

b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold
increases by 20 percent. The firm is able to keep all other expenses the
same. Assume a tax rate of 30 percent on income before taxes. What is
income after taxes and the profit margin for 20X2?

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Chapter 3 Financial Analysis 79

7. The Haines Corp. shows the following financial data for 20X1 and 20X2: Profitability ratios
(LO3-2)
20X1 20X2
Sales ................................................................................ $3,230,000 $3,370,000
Cost of goods sold .......................................................... 2,130,000 2,850,000
Gross profit ...................................................................... $1,100,000 $ 520,000
Selling & administrative expense ..................................... 298,000 227,000
Operating profit ............................................................... $ 802,000 $ 293,000
Interest expense .............................................................. 47,200 51,600
Income before taxes ........................................................ $ 754,800 $ 241,400
Taxes (35%) ..................................................................... 264,180 84,490
Income after taxes ........................................................... $ 490,620 $ 156,910

For each year, compute the following and indicate whether it is increasing or
decreasing profitability in 20X2 as indicated by the ratio:
a. Cost of goods sold to sales.
b. Selling and administrative expense to sales.
c. Interest expenses to sales.
8. Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of Profitability ratios
debt. It reports net income of $200,000. (LO3-2)
a. What is the firm’s return on assets?
b. What is its return on stockholders’ equity?
c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin
(return on sales)?
9. Network Communications has total assets of $1,500,000 and current assets of Profitability ratios
$612,000. It turns over its fixed assets three times a year. It has $319,000 of debt. (LO3-2)
Its return on sales is 8 percent. What is its return on stockholders’ equity?
10. Fondren Machine Tools has total assets of $3,310,000 and current assets of Profitability ratios
$879,000. It turns over its fixed assets 3.6 times per year. Its return on sales is (LO3-2)
4.8 percent. It has $1,750,000 of debt. What is its return on stockholders’ equity?
11. Baker Oats had an asset turnover of 1.6 times per year. Profitability ratios
a. If the return on total assets (investment) was 11.2 percent, what was Baker’s (LO3-2)
profit margin?
b. The following year, on the same level of assets, Baker’s assets turnover
declined to 1.4 times and its profit margin was 8 percent. How did the return
on total assets change from that of the previous year?
12. AllState Trucking Co. has the following ratios compared to its industry for last year: Du Pont system
of analysis
AllState (LO3-3)
Trucking Industry
Return on sales ..................................................................... 3% 8%
Return on assets ................................................................... 15% 10%

Explain why the return-on-assets ratio is so much more favorable than the
return-on-sales ratio compared to the industry. No numbers are necessary;
a one-sentence answer is all that is required.

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80 Part 2 Financial Analysis and Planning

Du Pont system 13. Front Beam Lighting Company has the following ratios compared to its industry
of analysis for last year:
(LO3-3)
Front Beam
Lighting Industry
Return on assets ................................................................... 12% 5%
Return on equity .................................................................... 16% 20%

Explain why the return-on-equity ratio is so much less favorable than the
return-on-assets ratio compared to the industry. No numbers are necessary;
a one-sentence answer is all that is required.
Du Pont system 14. Gates Appliances has a return-on-assets (investment) ratio of 8 percent.
of analysis a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity?
(LO3-3)
b. If the firm had no debt, what would the return-on-equity ratio be?

Intermediate Problems
Du Pont system 15. Using the Du Pont method, evaluate the effects of the following relationships for
of analysis the Butters Corporation:
(LO3-3) a. Butters Corporation has a profit margin of 7 percent and its return on assets
(investment) is 25.2 percent. What is its assets turnover?
b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what
would the firm’s return on equity be?
c. What would happen to return on equity if the debt-to-total-assets ratio
decreased to 35 percent?
Du Pont system 16. Jerry Rice and Grain Stores has $4,780,000 in yearly sales. The firm earns
of analysis 4.5 percent on each dollar of sales and turns over its assets 2.7 times per year. It
(LO3-3) has $123,000 in current liabilities and $349,000 in long-term liabilities.
a. What is its return on stockholders’ equity?
b. If the asset base remains the same as computed in part a, but total asset
turnover goes up to 3, what will be the new return on stockholders’ equity?
Assume that the profit margin stays the same as do current and long-term
liabilities.
Interpreting results 17. Assume the following data for Cable Corporation and Multi-Media Inc.
from the Du Pont
system of analysis
Cable Multi-Media
(LO3-3)
Corporation Inc.
Net income ................................................................. $ 31,200 $ 140,000
Sales ........................................................................... 317,000 2,700,000
Total assets ................................................................. 402,000 965,000
Total debt .................................................................... 163,000 542,000
Stockholders’ equity .................................................. 239,000 423,000

a. Compute the return on stockholders’ equity for both firms using Ratio 3a.
Which firm has the higher return?

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Chapter 3 Financial Analysis 81

b. Compute the following additional ratios for both firms:

Net income/Sales
Net income/Total assets
Sales/Total assets
Debt/Total assets
c. Discuss the factors from part b that added or detracted from one firm
having a higher return on stockholders’ equity than the other firm as
computed in part a.
18. A firm has sales of $3 million, and 10 percent of the sales are for cash. The Average collection
year-end accounts receivable balance is $285,000. What is the average collection period
period? (Use a 360-day year.) (LO3-2)

19. Martin Electronics has an accounts receivable turnover equal to 15 times. If Average daily sales
accounts receivable are equal to $80,000, what is the value for average daily (LO3-2)
credit sales?
20. Perez Corporation has the following financial data for the years 20X1 and 20X2: Inventory turnover
(LO3-2)
20X1 20X2
Sales ........................................................................... $8,000,000 $10,000,000
Cost of goods sold ..................................................... 6,000,000 9,000,000
Inventory ..................................................................... 800,000 1,000,000

a. Compute inventory turnover based on Ratio 6, Sales/Inventory, for each

year.
b. Compute inventory turnover based on an alternative calculation that is used
by many financial analysts, Cost of goods sold/Inventory, for each year.
c. What conclusions can you draw from part a and part b?

21. Jim Short’s Company makes clothing for schools. Sales in 20X1 were Turnover ratios
$4,820,000. Assets were as follows: (LO3-2)

Cash ............................................................................... $ 163,000

Accounts receivable ....................................................... 889,000
Inventory ......................................................................... 411,000
Net plant and equipment ................................................ 520,000
Total assets ............................................................... $1,983,000

a. Compute the following:

1. Accounts receivable turnover.
2. Inventory turnover.
3. Fixed asset turnover.
4. Total asset turnover.

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82 Part 2 Financial Analysis and Planning

b. In 20X2, sales increased to $5,740,000 and the assets for that year were as
follows:
Cash ................................................................................. $ 163,000
Accounts receivable ......................................................... 924,000
Inventory ........................................................................... 1,063,000
Net plant and equipment .................................................. 520,000
Total assets ................................................................. $2,670,000

Once again, compute the four ratios.

c. Indicate if there is an improvement or decline in total asset turnover, and
based on the other ratios, indicate why this development has taken place.
22. The balance sheet for Stud Clothiers is shown below. Sales for the year were
Overall ratio $2,400,000, with 90 percent of sales sold on credit.
analysis
STUD CLOTHIERS
(LO3-2)
Balance Sheet 20X1

Assets Liabilities and Equity

Cash .......................................... $ 60,000 Accounts payable ...................... $ 220,000
Accounts receivable .................. 240,000 Accrued taxes ........................... 30,000
Inventory .................................... 350,000 Bonds payable (long-term) ........ 150,000
Plant and equipment ................. 410,000 Common stock .......................... 80,000
Paid-in capital ........................... 200,000
Retained earnings ..................... 380,000
Total assets ........................ $1,060,000 Total liabilities and equity ... $1,060,000

Compute the following ratios:

a. Current ratio.
b. Quick ratio.
c. Debt-to-total-assets ratio.
d. Asset turnover.
e. Average collection period.
23. The Lancaster Corporation’s income statement is given below.
Debt utilization a. What is the times-interest-earned ratio?
ratios b. What would be the fixed-charge-coverage ratio?
(LO3-2)
LANCASTER CORPORATION

Sales ............................................................................ $246,000

Cost of goods sold ...................................................... 122,000
Gross profit .................................................................. $124,000
Fixed charges (other than interest) .............................. 27,500
Income before interest and taxes ................................ $ 96,500
Interest ......................................................................... 21,800
Income before taxes .................................................... $ 74,700
Taxes (35%) ................................................................. 26,145
Income after taxes ....................................................... $ 48,555

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Chapter 3 Financial Analysis 83

24. Using the income statement for Times Mirror and Glass Co., compute the fol-
lowing ratios: Debt utilization
a. The interest coverage. and Du Pont
b. The fixed charge coverage. system of analysis
(LO3-3)
The total assets for this company equal $80,000. Set up the equation for the
Du Pont system of ratio analysis, and compute c, d, and e.
c. Profit margin.
d. Total asset turnover.
e. Return on assets (investment).

TIMES MIRROR AND GLASS COMPANY

Sales ........................................................................ $126,000

Less: Cost of goods sold ........................................ 93,000
Gross profit .............................................................. $ 33,000
Less: Selling and administrative expense ............... 11,000
Less: Lease expense ............................................... 4,000
Operating profit* ...................................................... $ 18,000
Less: Interest expense ............................................ 3,000
Earnings before taxes .............................................. $ 15,000
Less: Taxes (30%) ................................................... 4,500
Earnings after taxes ................................................. $ 10,500

*Equals income before interest and taxes.

25. A firm has net income before interest and taxes of $193,000 and interest expense Debt utilization
of $28,100. (LO3-2)
a. What is the times-interest-earned ratio?
b. If the firm’s lease payments are $48,500, what is the fixed charge
coverage?

Advanced Problems
26. In January 2007, the Status Quo Company was formed. Total assets were Return on assets
$544,000, of which $306,000 consisted of depreciable fixed assets. Status analysis (LO3-2)
Quo uses straight-line depreciation of $30,600 per year, and in 2007 it esti-
mated its fixed assets to have useful lives of 10 years. Aftertax income has
been $29,000 per year each of the last 10 years. Other assets have not changed
since 2007.
a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016.
(Use $29,000 in the numerator for each year.)
b. To what do you attribute the phenomenon shown in part a?
c. Now assume income increased by 10 percent each year. What effect
would this have on your preceding answers? (A comment is all that is
necessary.)

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84 Part 2 Financial Analysis and Planning

Trend analysis 27. Jolie Foster Care Homes Inc. shows the following data:
(LO3-4)
Year Net Income Total Assets Stockholders’ Equity Total Debt
20X1 $155,000 $2,390,000 $ 761,000 $1,629,000
20X2 191,000 2,700,000 966,000 1,734,000
20X3 208,000 2,730,000 1,770,000 960,000
20X4 192,000 2,470,000 2,220,000 250,000

a. Compute the ratio of net income to total assets for each year and comment
on the trend.
b. Compute the ratio of net income to stockholders’ equity and comment on
the trend. Explain why there may be a difference in the trends between parts
a and b.
Trend analysis 28. Quantum Moving Company has the following data. Industry information also is
(LO3-4) shown.

Company Data Industry Data on

Net Income/Total Assets
Year Net Income Total Assets
20X1 $424,000 $2,843,000 14.0%
20X2 428,000 3,267,000 9.8
20X3 412,000 3,834,000 3.9
Industry Data on
Year Debt Total Assets Debt/Total Assets
20X1 $1,722,000 $2,843,000 56.6%
20X2 1,732,000 3,267,000 42.0
20X3 1,950,000 3,834,000 38.0

As an industry analyst comparing the firm to the industry, are you likely to praise
or criticize the firm in terms of the following?
a. Net income/Total assets.
b. Debt/Total assets.
Analysis by divisions 29. The Global Products Corporation has three subsidiaries.
(LO3-2)
Medical Supplies Heavy Machinery Electronics
Sales ........................................... $20,040,000 $5,980,000 $4,730,000
Net income (after taxes) ............. 1,700,000 592,000 402,000
Assets ......................................... 8,340,000 8,760,000 3,570,000

a. Which division has the lowest return on sales?

b. Which division has the highest return on assets?
c. Compute the return on assets for the entire corporation.
d. If the $8,760,000 investment in the heavy machinery division is sold off and
redeployed in the medical supplies subsidiary at the same rate of return on
assets currently achieved in the medical supplies division, what will be the
new return on assets for the entire corporation?

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Chapter 3 Financial Analysis 85

30. Omni Technology Holding Company has the following three affiliates: Analysis by
affiliates
Personal Foreign (LO3-1)
Software Computers Operations
Sales ........................................ $40,200,000 $60,080,000 $100,680,000
Net income (after taxes) .......... 2,086,000 2,880,000 8,510,000
Assets ...................................... 5,820,000 25,790,000 60,630,000
Stockholders’ equity ............... 4,090,000 10,170,000 50,950,000

a.Which affiliate has the highest return on sales?

b.Which affiliate has the lowest return on assets?
c.Which affiliate has the highest total asset turnover?
d.Which affiliate has the highest return on stockholders’ equity?
e.Which affiliate has the highest debt ratio? (Assets minus stockholders’
equity equals debt.)
f. Returning to question b, explain why the software affiliate has the highest
return on total assets.
g. Returning to question d, explain why the personal computer affiliate has a
higher return on stockholders’ equity than the foreign operations affiliate
even though it has a lower return on total assets.
31. The Canton Corporation shows the following income statement. The firm uses Inflation and
FIFO inventory accounting. inventory
accounting effect
CANTON CORPORATION (LO3-5)
Income Statement for 20X1

Sales ........................................................... $272,800 (17,600 units at $15.50)

Cost of goods sold ..................................... 123,200 (17,600 units at $7.00)
Gross profit ................................................. $149,600
Selling and administrative expense ............ 13,640
Depreciation ............................................... 15,900
Operating profit .......................................... $120,060
Taxes (30%) ................................................ 36,018
Aftertax income .......................................... $ 84,042

a. Assume in 20X2 the same 17,600-unit volume is maintained, but that the
sales price increases by 10 percent. Because of FIFO inventory policy, old
inventory will still be charged off at $7 per unit. Also assume selling and
administrative expense will be 5 percent of sales and depreciation will be
unchanged. The tax rate is 30 percent. Compute aftertax income for 20X2.
b. In part a, by what percent did aftertax income increase as a result of a 10
percent increase in the sales price? Explain why this impact took place.
c. Now assume that in 20X3 the volume remains constant at 17,600 units,
but the sales price decreases by 15 percent from its year 20X2 level. Also,
because of FIFO inventory policy, cost of goods sold reflects the inflation-
ary conditions of the prior year and is $7.50 per unit. Further, assume selling
and administrative expense will be 5 percent of sales and depreciation will
be unchanged. The tax rate is 30 percent. Compute the aftertax income.

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86 Part 2 Financial Analysis and Planning

Using ratios to 32. Construct the current assets section of the balance sheet from the following data.
construct financial (Use cash as a plug figure after computing the other values.)
statements
(LO3-2) Yearly sales (credit) .......................................................................................... $420,000
Inventory turnover ........................................................................................... 7 times
Current liabilities .............................................................................................. $80,000
Current ratio .................................................................................................... 2
Average collection period ................................................................................ 36 days
Current assets: $
Cash ..................................................................................... ___________
Accounts receivable ............................................................ ___________
Inventory .............................................................................. ___________
Total current assets .......................................................... ___________

Using ratios to 33. The Griggs Corporation has credit sales of $1,200,000. Given these ratios, fill in
construct financial the following balance sheet.
statements
(LO3-2) Total assets turnover ......................................................................................... 2.4 times
Cash to total assets ........................................................................................... 2.0%
Accounts receivable turnover ............................................................................ 8.0 times
Inventory turnover ............................................................................................. 10.0 times
Current ratio ...................................................................................................... 2.0 times
Debt to total assets ........................................................................................... 61.0%

GRIGGS CORPORATION
Balance Sheet

Assets Liabilities and Stockholders’ Equity

Cash ................................... ________ Current debt ..................................... ________
Accounts receivable ........... ________ Long-term debt ................................ ________
Inventory ............................. ________ Total debt ...................................... ________
Total current assets ......... ________ Equity ............................................... ________
Fixed assets ....................... ________ Total debt and
Total assets ..................... ________ stockholders’ equity ................... ________

Using ratios to 34. We are given the following information for the Pettit Corporation.
determine account
balances Sales (credit) .................................................................................................. $3,549,000
(LO3-2) Cash .............................................................................................................. 179,000
Inventory ........................................................................................................ 911,000
Current liabilities ............................................................................................ 788,000
Asset turnover ............................................................................................... 1.40 times
Current ratio .................................................................................................. 2.95 times
Debt-to-assets ratio ...................................................................................... 40%
Receivables turnover ..................................................................................... 7 times

Current assets are composed of cash, marketable securities, accounts receivable,

and inventory. Calculate the following balance sheet items.
a. Accounts receivable.
b. Marketable securities.

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Chapter 3 Financial Analysis 87

c. Fixed assets.
d. Long-term debt.

35. The following information is from Harrelson Inc.’s financial statements. Sales Using ratios to
(all credit) were $28.50 million for last year. construct financial
statements
(LO3-2)
Sales to total assets .......................................................................................... 1.90 times
Total debt to total assets .................................................................................. 35%
Current ratio ....................................................................................................... 2.50 times
Inventory turnover ............................................................................................. 10.00 times
Average collection period .................................................................................. 20 days
Fixed asset turnover .......................................................................................... 5.00 times

Fill in the balance sheet:

Cash ............................................ _______ Current debt ................................. _______

Accounts receivable .................... _______ Long-term debt ............................ _______
Inventory ...................................... _______ Total debt .................................. _______
Total current assets .................. _______ Equity ........................................... _______
Fixed assets ................................ _______ Total debt and equity ................ _______
Total assets .............................. _______

36. Using the financial statements for the Snider Corporation, calculate the 13 basic
ratios found in the chapter. Comparing all
the ratios
SNIDER CORPORATION (LO3-2)
Balance Sheet
December 31, 20X1

Assets
Current assets:
Cash ........................................................................................ $ 52,200
Marketable securities .............................................................. 24,400
Accounts receivable (net) ........................................................ 222,000
Inventory ................................................................................. 238,000
Total current assets ............................................................. $536,600
Investments ................................................................................ 65,900
Plant and equipment .................................................................. $615,000
Less: Accumulated depreciation ............................................ (271,000)
Net plant and equipment ........................................................ $344,000
Total assets ................................................................................. $946,500
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable ................................................................... $ 93,400
Notes payable ......................................................................... 70,600
Accrued taxes ......................................................................... 17,000
Total current liabilities .......................................................... $181,000
(continued)

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88 Part 2 Financial Analysis and Planning

(continued)

SNIDER CORPORATION
Balance Sheet
December 31, 20X1

Long-term liabilities:
Bonds payable ........................................................................ $153,200
Total liabilities .......................................................................... $334,200
Stockholders’ equity:
Preferred stock, $50 per value ................................................ $100,000
Common stock, $1 par value .................................................. 80,000
Capital paid in excess of par .................................................. 190,000
Retained earnings ................................................................... 242,300
Total stockholders’ equity ................................................... $612,300
Total liabilities and stockholders’ equity ..................................... $946,500

SNIDER CORPORATION
Income statement
For the Year Ending December 31, 20X1

Sales (on credit) ........................................................................... $2,064,000

Less: Cost of goods sold ......................................................... 1,313,000
Gross profit .................................................................................. $ 751,000
Less: Selling and administrative expenses .............................. 496,000*
Operating profit (EBIT) ................................................................. $ 255,000
Less: Interest expense ............................................................. 26,900
Earnings before taxes (EBT) ........................................................ $ 228,100
Less: Taxes .............................................................................. 83,300
Earnings after taxes (EAT) ........................................................... $ 144,800

*Includes $36,100 in lease payments.

37. Given the financial statements for Jones Corporation and Smith Corporation
Ratio computation shown here:
and analysis a. To which one would you, as credit manager for a supplier, approve the exten-
(LO3-2) sion of (short-term) trade credit? Why? Compute all ratios before answering.
b. In which one would you buy stock? Why?

JONES CORPORATION

Current Assets Liabilities

Cash .................................................. $ 20,000 Accounts payable ...................... $100,000
Accounts receivable .......................... 80,000 Bonds payable (long-term) ........ 80,000
Inventory ............................................ 50,000
Long-Term Assets Stockholders’ Equity
Fixed assets ...................................... $500,000 Common stock .......................... $150,000
Less: Accumulated depreciation ... (150,000) Paid-in capital ........................... 70,000
Net fixed assets* ............................... 350,000 Retained earnings ..................... 100,000
Total assets ................................ $500,000 Total liab. and equity .............. $500,000
(continued)

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Chapter 3 Financial Analysis 89

(continued)

JONES CORPORATION
Sales (on credit) ............................................. $1,250,000
Cost of goods sold ........................................ 750,000
Gross profit .................................................... $ 500,000
Selling and administrative expense† ............ 257,000
Less: Depreciation expense ........................ 50,000
Operating profit ............................................. $ 193,000
Interest expense ............................................ 8,000
Earnings before taxes .................................... $ 185,000
Tax expense .................................................. 92,500
Net income .................................................... $ 92,500

*Use net fixed assets in computing fixed asset turnover.

†
Includes $7,000 in lease payments.

SMITH CORPORATION

Current Assets Liabilities

Cash .................................................. $ 35,000 Accounts payable ........................ $ 75,000
Marketable securities ........................ 7,500 Bonds payable (long-term) .......... 210,000
Accounts receivable .......................... 70,000
Inventory ............................................ 75,000

Long-Term Assets Stockholders’ Equity

Fixed assets ...................................... $500,000 Common stock ............................ $ 75,000
Less: Accum. dep .......................... (250,000) Paid-in capital ............................. 30,000
Net fixed assets* ............................... 250,000 Retained earnings ....................... 47,500
Total assets ................................ $437,500 Total liab. and equity ................ $437,500

*Use net fixed assets in computing fixed asset turnover.

SMITH CORPORATION

Sales (on credit) ........................................... $1,000,000

Cost of goods sold ...................................... 600,000
Gross profit .................................................. $ 400,000
Selling and administrative expense† ............ 224,000
Depreciation expense .................................. 50,000
Operating profit ............................................ $ 126,000
Interest expense .......................................... 21,000
Earnings before taxes .................................. $ 105,000
Tax expense ................................................. 52,500
Net income .................................................. $ 52,500

†
Includes $7,000 in lease payments.

C O M P R E H E N S I V E P R O B L E M

Bob Adkins has recently been approached by his first cousin, Ed Lamar, with a pro- Lamar Swimwear
posal to buy a 15 percent interest in Lamar Swimwear. The firm manufactures stylish (Trend analysis
bathing suits and sunscreen products. and industry
Mr. Lamar is quick to point out the increase in sales that has taken place over the comparisons)
last three years as indicated in the income statement, Exhibit 1. The annual growth (LO3)

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90 Part 2 Financial Analysis and Planning

rate is 25 percent. A balance sheet for a similar time period is shown in Exhibit 2, and
selected industry ratios are presented in Exhibit 3. Note the industry growth rate in
sales is only 10 to 12 percent per year.
There was a steady real growth of 3 to 4 percent in gross domestic product during
the period under study.

Exhibit 1

LAMAR SWIMWEAR
Income Sheet

20X1 20X2 20X3

Sales (all on credit) .................................... $1,200,000 $1,500,000 $1,875,000
Cost of goods sold .................................... 800,000 1,040,000 1,310,000
Gross profit ................................................ $ 400,000 $ 460,000 $ 565,000
Selling and administrative expense* ......... 239,900 274,000 304,700
Operating profit (EBIT) ............................... $ 160,100 $ 186,000 $ 260,300
Interest expense ........................................ 35,000 45,000 85,000
Net income before taxes ........................... $ 125,100 $ 141,000 $ 175,300
Taxes ......................................................... 36,900 49,200 55,600
Net Income ................................................ $ 88,200 $ 91,800 $ 119,700
Shares ....................................................... 30,000 30,000 38,000
Earnings per share .................................... $2.94 $3.06 $3.15
*Includes $15,000 in lease payments for each year.

Exhibit 2

LAMAR SWIMWEAR
Balance Sheet

Assets 20X1 20X2 20X3

Cash ............................................................ $ 30,000 $ 40,000 $ 30,000
Marketable securities .................................. 20,000 25,000 30,000
Accounts receivable .................................... 170,000 259,000 360,000
Inventory ...................................................... 230,000 261,000 290,000
Total current assets .................................. $ 450,000 $ 585,000 $ 710,000
Net plant and equipment ............................. 650,000 765,000 1,390,000
Total assets .................................................. $1,100,000 $1,350,000 $2,100,000

Liabilities and Stockholders’ Equity

Accounts payable ........................................ $ 200,000 $ 310,000 $ 505,000
Accrued expenses ....................................... 20,400 30,000 35,000
Total current liabilities .............................. $ 220,400 $ 340,000 $ 540,000
Long-term liabilities ..................................... 325,000 363,600 703,900
Total liabilities ........................................... $ 545,400 $ 703,600 $1,243,900
Common stock ($2 par) ............................... 60,000 60,000 76,000
Capital paid in excess of par ....................... 190,000 190,000 264,000
Retained earnings ....................................... 304,600 396,400 516,100
Total stockholders’ equity ........................ $ 554,600 $ 646,400 $ 856,100
Total liabilities and stockholders’ equity ...... $1,100,000 $1,350,000 $2,100,000

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Chapter 3 Financial Analysis 91

Exhibit 3

Selected Industry Ratios

20X1 20X2 20X3

Growth in sales ........................................... — 10.00% 12.00%
Profit margin ............................................... 7.71% 7.82% 7.96%
Return on assets (investment) .................... 7.94% 8.86% 8.95%
Return on equity ......................................... 14.31% 15.26% 16.01%
Receivable turnover .................................... 9.02X 8.86X 9.31X
Average collection period ........................... 39.9 days 40.6 days 38.7 days
Inventory turnover ...................................... 4.24X 5.10X 5.11X
Fixed asset turnover ................................... 1.60X 1.64X 1.75X
Total asset turnover .................................... 1.05X 1.10X 1.12X
Current ratio ............................................... 1.96X 2.25X 2.40X
Quick ratio .................................................. 1.37X 1.41X 1.38X
Debt to total assets .................................... 43.47% 43.11% 44.10%
Times interest earned ................................. 6.50X 5.99X 6.61X
Fixed charge coverage ............................... 4.70X 4.69X 4.73X
Growth in EPS ............................................ — 10.10% 13.30%

The stock in the corporation has become available due to the ill health of a current
stockholder, who is in need of cash. The issue here is not to determine the exact price
for the stock, but rather whether Lamar Swimwear represents an attractive investment
situation. Although Mr. Adkins has a primary interest in the profitability ratios, he will
take a close look at all the ratios. He has no fast and firm rules about required return
on investment, but rather wishes to analyze the overall condition of the firm. The firm
does not currently pay a cash dividend, and return to the investor must come from sell-
ing the stock in the future. After doing a thorough analysis (including ratios for each
year and comparisons to the industry), what comments and recommendations do you
offer to Mr. Adkins?

C O M P R E H E N S I V E P R O B L E M

Sun Microsystems is a leading supplier of computer-related products, including servers, Sun Microsystems
workstations, storage devices, and network switches. In 2009, Sun Microsystems was (Trends, ratios, stock
acquired by Oracle Corporation. performance)
In the letter to stockholders as part of the 2001 annual report, President and CEO (LO3)
Scott G. McNealy offered the following remarks:
Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole.
Still, we finished with revenue growth of 16 percent—and that’s significant. We believe
it’s a good indication that Sun continued to pull away from the pack and gain market
share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively
brought costs down—even as they continued to bring exciting new products to market.

The statement would not appear to be telling you enough. For example, McNealy says
the year was a mixed bag with revenue growth of 16 percent. But what about earnings?

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92 Part 2 Financial Analysis and Planning

You can delve further by examining the income statement in Exhibit 4. Also, for
additional analysis of other factors, consolidated balance sheet(s) are presented in
Exhibit 5.
1. Referring to Exhibit 4, compute the annual percentage change in net income per
common share-diluted (second numerical line from the bottom) for 1998–1999,
1999–2000, and 2000–2001.
2. Also in Exhibit 4, compute net income/net revenue (sales) for each of the four
years. Begin with 1998.
3. What is the major reason for the change in the answer for Question 2 between
2000 and 2001? To answer this question for each of the two years, take the ratio
of the major income statement accounts to net revenues (sales).
Cost of sales
Research and development
Selling, general and administrative expense
Provision for income tax
4. Compute return on stockholders’ equity for 2000 and 2001 using data from
Exhibits 4 and 5.
Exhibit 4

SUN MICROSYSTEMS INC.

Summary Consolidated Statement of Income (in millions)

2001 2000 1999 1998

Dollars Dollars Dollars Dollars
Net revenues .............................................. $18,250 $15,721 $11,806 $9,862
Costs and expenses:
Cost of sales ........................................... $10,041 $ 7,549 $ 5,670 $4,713
Research and development .................... 2,016 1,630 1,280 1,029
Selling, general and administrative ......... 4,544 4,072 3,196 2,826
Goodwill amortization ............................. 261 65 19 4
In-process research and development ... 77 12 121 176
Total costs and expenses ........................... $16,939 $13,328 $10,286 $8,748
Operating income ....................................... 1,311 2,393 1,520 1,114
Gain (loss) on strategic investments .......... (90) 208 — —
Interest income, net .................................... 363 170 85 48
Litigation settlement ................................... — — — —
Income before taxes ................................... $ 1,584 $ 2,771 $ 1,605 $1,162
Provision for income taxes ......................... 603 917 575 407
Cumulative effect of change in
accounting principle, net ........................ (54) — — —
Net income ................................................. $ 927 $ 1,854 $ 1,030 $ 755
Net income per common share-diluted ...... $ 0.27 $ 0.55 $ 0.31 $ 0.24
Shares used in the calculation of net
income per common share-diluted ........ 3,417 3,379 3,282 3,180

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Chapter 3 Financial Analysis 93

Exhibit 5

SUN MICROSYSTEMS INC.

Consolidated Balance Sheets (in millions)

2001 2000
Assets
Current assets:
Cash and cash equivalents ....................................................... $ 1,472 $ 1,849
Short-term investments ............................................................ 387 626
Accounts receivable, net of allowances of $410 in 2001 2,955 2,690
and $534 in 2000 ..................................................................
Inventories ................................................................................ 1,049 557
Deferred tax assets ................................................................... 1,102 673
Prepaids and other current assets ............................................ 969 482
Total current assets ............................................................... $ 7,934 $ 6,877
Property, plant and equipment, net .............................................. 2,697 2,095
Long-term investments ................................................................ 4,677 4,496
Goodwill, net of accumulated amortization of $349 in 2001
and $88 in 2000 ........................................................................ 2,041 163
Other assets, net .......................................................................... 832 521
$18,181 $14,152
Liabilities and Stockholders’ Equity
Current liabilities:
Short-term borrowings .............................................................. $ 3 $ 7
Accounts payable ..................................................................... 1,050 924
Accrued payroll-related liabilities .............................................. 488 751
Accrued liabilities and other ..................................................... 1,374 1,155
Deferred revenues and customer deposits ............................... 1,827 1,289
Warranty reserve ....................................................................... 314 211
Income taxes payable ............................................................... 90 209
Total current liabilities ............................................................ $ 5,146 $ 4,546
Deferred income taxes ................................................................. 744 577
Long-term debt and other obligations ......................................... 1,705 1,720
Total debt .............................................................................. $ 7,595 $ 6,843
Commitments and contingencies ................................................
Stockholders’ equity:
Preferred stock, $0.001 par value, 10 shares authorized
(1 share which has been designated as Series A Preferred
participating stock); no shares issued and outstanding ..... — —
Common stock and additional paid-in-capital, $0.00067
par value, 7,200 shares authorized; issued: 3,536 shares
in 2001 and 3,495 shares in 2000 ..................................... 6,238 2,728
Treasury stock, at cost: 288 shares in 2001 and 301
shares in 2000 ....................................................................... (2,435) (1,438)
Deferred equity compensation ................................................. (73) (15)
Retained earnings ..................................................................... 6,885 5,959
Accumulated other comprehensive income (loss) .................... (29) 75
Total stockholders’ equity ..................................................... $10,586 $ 7,309
$18,181 $14,152

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94 Part 2 Financial Analysis and Planning

5. Analyze your results in Question 4 more completely by computing Ratios 1,

2a, 2b, and 3b (all from this chapter) for 2000 and 2001. Actually the answer to
Ratio 1 can be found as part of the answer to Question 2, but it is helpful to look
at it initially.
What do you think was the main contributing factor to the change in return
on stockholders’ equity between 2000 and 2001? Think in terms of the Du Pont
system of analysis.
6. The average stock prices for each of the four years shown in Exhibit 4 were as
follows:
1998 11¼
1999 16¾
2000 28½
2001 9½
a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock
price shown above and divide by net income per common stock-dilution
from Exhibit 4.
b. Why do you think the P/E has changed from its 2000 level to its 2001 level?
A brief review of P/E ratios can be found under the topic of Price-Earnings
Ratio Applied to Earnings per Share in Chapter 2.
7. The book values per share for the same four years discussed in the preceding
question were:
1998 $1.18
1999 $1.55
2000 $2.29
2001 $3.26
a. Compute the ratio of price to book value for each year.
b. Is there any dramatic shift in the ratios worthy of note?

W E B E X E R C I S E

1. IBM was mentioned in the chapter as having an uneven performance. Let’s check
this out. Go to its website, www.ibm.com, and follow the steps below. Under
“Information for” at the bottom of the page, select “Investors.” Select “Financial
Snapshot” on the next page.
2. Click on “Stock Chart.” How has IBM’s stock been doing recently?
3. Click on “Financial Snapshot.” Assuming IBM’s historical price-earnings ratio
is 18, how does it currently stand?
4. Assuming its annual dividend yield is 2.5 percent, how does it currently stand?

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Chapter 3 Financial Analysis 95

5. Assuming IBM’s historical “LT” (long-term) debt/equity is 100 percent, how

does it currently stand? Generally speaking, is that good or bad?
6. Assuming its historical return on assets is 10 percent, how does it currently
stand? Generally speaking, is that good or bad?

Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on
a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid
you in finding the topic you are looking for.

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