3 Working with Financial

Statements

I n February 2015, shares of famed motorcycle manufacturer

Harley-Davidson, Inc., were trading for about $62. At that price,
Harley-Davidson had a price–earnings, or PE, ratio of 16, meaning
LEARNING OBJECTIVES
After studying this chapter, you should
be able to:
that investors were willing to pay $16 for every dollar in income
earned by Harley-Davidson. At the same time, investors were will- Standardize financial statements
LO 1
for comparison purposes.
ing to pay $252 for each dollar earned by 3D printer company 3D
Compute and, more importantly,
Systems Corporation, but only a meager $6 and $9 for each dollar LO 2
interpret some common ratios.
earned by Marathon Oil and Citigroup, respectively. And then there Assess the determinants of a firm’s
LO 3
were stocks like Amazon which, despite having no earnings (a loss profitability and growth.

actually), had a stock price of about $370 per share. Meanwhile, Identify and explain some of the
LO 4
problems and pitfalls in financial
the average stock in the Standard & Poor’s (S&P) 500 index, which statement analysis.
contains 500 of the largest publicly traded companies in the United
States, had a PE ratio of about 17, so Harley-Davidson was average
in this regard.
As we look at these numbers, an obvious question arises: Why were investors willing to
pay so much for a dollar of 3D Systems’ earnings but so much less for a dollar earned by
Harley-Davidson? To understand the answer, we need to delve into subjects such as relative
profitability and growth potential, and we also need to know how to compare financial and
operating information across companies. By a remarkable coincidence, that is precisely what
this chapter is about.
The PE ratio is just one example of a financial ratio. As we will see in this chapter, there
are a wide variety of such ratios, all designed to summarize specific aspects of a firm’s finan-
cial position. In addition to discussing financial ratios and what they mean, we will have quite
a bit to say about who uses this information and why.
Everybody needs to understand ratios. Managers will find that almost every business
characteristic, from profitability to employee productivity, is summarized in some kind of ra-
tio. Marketers examine ratios dealing with costs, markups, and margins. Production

Please visit us at essentialsofcorporatefinance.blogspot.com for the latest developments in the world

worldof
ofcorporate
corporatefinance.
finance.

51
 personnel focus on ratios dealing with issues such as operating efficiency. Accountants need
to understand ratios because, among other things, ratios are one of the most common and
important forms of financial statement information.
In fact, regardless of your field, you may very well find that your compensation is tied to
some ratio or group of ratios. Perhaps that is the best reason to study up!

I n Chapter 2, we discussed some of the essential concepts of financial statements and

cash flows. This chapter continues where our earlier discussion left off. Our goal here
is to expand your understanding of the uses (and abuses) of financial statement
information.
A good working knowledge of financial statements is desirable simply because
such statements, and numbers derived from those statements, are the primary means of
communicating financial information both within the firm and outside the firm. In
short, much of the language of business finance is rooted in the ideas we discuss in this
chapter.
Company financial In the best of all worlds, the financial manager has full market value information about
information can be found all of the firm’s assets. This will rarely (if ever) happen. So, the reason we rely on account-
in many places on the ing figures for much of our financial information is that we are almost always unable to
web, including www. obtain all (or even part) of the market information that we want. The only meaningful
financials.com and yardstick for evaluating business decisions is whether or not they create economic value
finance.google.com.
(see Chapter 1). However, in many important situations, it will not be possible to make this
judgment directly because we can’t see the market value effects.
We recognize that accounting numbers are often just pale reflections of economic re-
ality, but they frequently are the best available information. For privately held corpora-
tions, not-for-profit businesses, and smaller firms, for example, very little direct market
value information exists at all. The accountant’s reporting function is crucial in these
circumstances.
Clearly, one important goal of the accountant is to report financial information to the
user in a form useful for decision making. Ironically, the information frequently does not
come to the user in such a form. In other words, financial statements don’t come with a
user’s guide. This chapter is a first step in filling this gap.

3.1 STANDARDIZED FINANCIAL STATEMENTS

Excel One obvious thing we might want to do with a company’s financial statements is to com-
Master pare them to those of other, similar companies. We would immediately have a problem,
coverage online
however. It’s almost impossible to directly compare the financial statements for two com-
panies because of differences in size.
For example, Ford and GM are obviously serious rivals in the auto market, but GM
was historically much larger (in terms of assets), so it was difficult to compare them di-
rectly. For that matter, it’s difficult to even compare financial statements from different
points in time for the same company if the company’s size has changed. The size problem
is compounded if we try to compare GM and, say, Toyota. If Toyota’s financial statements
are denominated in yen, then we have a size and a currency difference.
52
 CHAPTER 3 Working with Financial Statements 53

PRUFROCK CORPORATION T A B L E 3.1

Balance Sheets as of December 31, 2015 and 2016
($ in millions)

2015 2016
Assets
Current assets
Cash $ 84 $ 98
Accounts receivable 165 188
Inventory 393 422
Total $ 642 $ 708
Fixed assets
Net plant and equipment $2,731 $2,880
Total assets $3,373 $3,588

Liabilities and Owners’ Equity

Current liabilities
Accounts payable $ 312 $ 344
Notes payable 231 196
Total $ 543 $ 540
Long-term debt $ 531 $ 457
Owners’ equity
Common stock and paid-in surplus $ 500 $ 550
Retained earnings 1,799 2,041
Total $2,299 $2,591
Total liabilities and owners’ equity $3,373 $3,588

To start making comparisons, one obvious thing we might try to do is to somehow

standardize the financial statements. One very common and useful way of doing this is to
work with percentages instead of total dollars. The resulting financial statements are called common-size
common-size statements. We consider these next. statements
A standardized financial
Common-Size Balance Sheets statement presenting all
items in percentage terms.
For easy reference, Prufrock Corporation’s 2015 and 2016 balance sheets are provided in Balance sheet items are
Table 3.1. Using these, we construct common-size balance sheets by expressing each item shown as a percentage of
as a percentage of total assets. Prufrock’s 2015 and 2016 common-size balance sheets are assets and income
statement items as a
shown in Table 3.2. percentage of sales.
Notice that some of the totals don’t check exactly because of rounding errors. Also
notice that the total change has to be zero because the beginning and ending numbers must
add up to 100 percent.
In this form, financial statements are relatively easy to read and compare. For ex-
ample, just looking at the two balance sheets for Prufrock, we see that current assets
were 19.7 percent of total assets in 2016, up from 19.0 percent in 2015. Current liabili- IBM’s website has a
ties declined from 16.1 percent to 15.1 percent of total liabilities and equity over that good guide to reading
same time. Similarly, total equity rose from 68.2 percent of total liabilities and equity to financial statements. Visit
72.2 percent. www.ibm.com/investor.
Overall, Prufrock’s liquidity, as measured by current assets compared to current liabil-
ities, increased over the year. Simultaneously, Prufrock’s indebtedness diminished as a
percentage of total assets. We might be tempted to conclude that the balance sheet has
grown “stronger.”
54 PART 2 Understanding Financial Statements and Cash Flow

T A B L E 3.2 PRUFROCK CORPORATION

Common-Size Balance Sheets
December 31, 2015 and 2016

2015 2016 Change

Assets
Current assets
Cash 2.5% 2.7% + .2%
Accounts receivable 4.9 5.2 + .3
Inventory 11.7 11.8 + .1
Total 19.0 19.7 + .7
Fixed assets
Net plant and equipment 81.0 80.3 − .7
Total assets 100.0% 100.0% 0%

Liabilities and Owners’ Equity

Current liabilities
Accounts payable 9.2% 9.6% + .3%
Notes payable 6.8 5.5 − 1.4
Total 16.1 15.1 − 1.0
Long-term debt 15.7 12.7 − 3.0
Owners’ equity
Common stock and paid-in surplus 14.8 15.3 + .5
Retained earnings 53.3 56.9 + 3.5
Total 68.2 72.2 + 4.1
Total liabilities and owners’ equity 100.0% 100.0% 0%

T A B L E 3.3 PRUFROCK CORPORATION

2016 Income Statement
($ in millions)

Sales $2,311
Cost of goods sold 1,344
Depreciation 276
Earnings before interest and taxes $ 691
Interest paid 141
Taxable income $ 550
Taxes (34%) 187
Net income $ 363
Dividends $121
Addition to retained earnings 242

Common-Size Income Statements

A useful way of standardizing the income statement shown in Table 3.3 is to express each
item as a percentage of total sales, as illustrated for Prufrock in Table 3.4.
This income statement tells us what happens to each dollar in sales. For Prufrock,
interest expense eats up $.061 out of every sales dollar, and taxes take another $.081.
When all is said and done, $.157 of each dollar flows through to the bottom line (net in-
come), and that amount is split into $.105 retained in the business and $.052 paid out in
dividends.
 CHAPTER 3 Working with Financial Statements 55

PRUFROCK CORPORATION T A B L E 3.4

Common-Size Income Statement
2016

Sales 100.0%
Cost of goods sold 58.2
Depreciation 11.9
Earnings before interest and taxes 29.9
Interest paid 6.1
Taxable income 23.8
Taxes (34%) 8.1
Net income 15.7%
Dividends 5.2%
Addition to retained earnings 10.5

These percentages are very useful in comparisons. For example, a very relevant figure
is the cost percentage. For Prufrock, $.582 of each $1.00 in sales goes to pay for goods
sold. It would be interesting to compute the same percentage for Prufrock’s main competi-
tors to see how Prufrock stacks up in terms of cost control.

CONCE P T Q U ES T I O N S
3.1a Why is it often necessary to standardize financial statements?
3.1b Describe how common-size balance sheets and income statements are formed.

3.2 RATIO ANALYSIS

Another way of avoiding the problems involved in comparing companies of different sizes
is to calculate and compare financial ratios. Such ratios are ways of comparing and investi- financial ratios
gating the relationships between different pieces of financial information. We cover some Relationships determined
of the more common ratios next, but there are many others that we don’t touch on. from a firm’s financial
information and used for
One problem with ratios is that different people and different sources frequently don’t comparison purposes.
compute them in exactly the same way, and this leads to much confusion. The specific
definitions we use here may or may not be the same as ones you have seen or will see else-
where. If you are ever using ratios as a tool for analysis, you should be careful to document
how you calculate each one, and, if you are comparing your numbers to those of another Excel
Master
source, be sure you know how their numbers are computed. coverage online
We will defer much of our discussion of how ratios are used and some problems that
come up with using them until a bit later in the chapter. For now, for each of the ratios we
discuss, several questions come to mind:
1. How is it computed?
2. What is it intended to measure, and why might we be interested?
3. What is the unit of measurement?
4. What might a high or low value be telling us? How might such values be misleading?
5. How could this measure be improved?
56 PART 2 Understanding Financial Statements and Cash Flow

Financial ratios are traditionally grouped into the following categories:

1. Short-term solvency, or liquidity, ratios.
2. Long-term solvency, or financial leverage, ratios.
3. Asset management, or turnover, ratios.
4. Profitability ratios.
5. Market value ratios.
We will consider each of these in turn. In calculating these numbers for Prufrock, we will
use the ending balance sheet (2016) figures unless we explicitly say otherwise. Also
notice that the various ratios are color keyed to indicate which numbers come from the
income statement income statement and which come from the balance sheet.
Financial statement
summarizing a firm’s
performance over a period
Short-Term Solvency, or Liquidity, Measures
of time. As the name suggests, short-term solvency ratios as a group are intended to provide infor-
balance sheet mation about a firm’s liquidity, and these ratios are sometimes called liquidity measures.
Financial statement The primary concern is the firm’s ability to pay its bills over the short run without undue
showing a firm’s stress. Consequently, these ratios focus on current assets and current liabilities.
accounting value on a
For obvious reasons, liquidity ratios are particularly interesting to short-term creditors.
particular date.
Because financial managers are constantly working with banks and other short-term lend-
ers, an understanding of these ratios is essential.
One advantage of looking at current assets and liabilities is that their book values and
market values are likely to be similar. Often (though not always), these assets and liabilities
just don’t live long enough for the two to get seriously out of step. On the other hand, like
any type of near cash, current assets and liabilities can and do change fairly rapidly, so to-
day’s amounts may not be a reliable guide to the future.

Current Ratio One of the best-known and most widely used ratios is the current ratio.
As you might guess, the current ratio is defined as:
Current assets
Current ratio = [3.1]
Current liabilities

For Prufrock, the 2016 current ratio is:

$708
Current ratio = = 1.31 times
$540

Because current assets and liabilities are, in principle, converted to cash over the
following 12 months, the current ratio is a measure of short-term liquidity. The unit of
measurement is either dollars or times. So, we could say Prufrock has $1.31 in current
assets for every $1 in current liabilities, or we could say Prufrock has its current liabilities
covered 1.31 times over.
To a creditor, particularly a short-term creditor such as a supplier, the higher the cur-
rent ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may
indicate an inefficient use of cash and other short-term assets. Absent some extraordinary
circumstances, we would expect to see a current ratio of at least 1, because a current ratio
of less than 1 would mean that net working capital (current assets less current liabilities)
is negative. This would be unusual in a healthy firm, at least for most types of
businesses.
The current ratio, like any ratio, is affected by various types of transactions. For
example, suppose the firm borrows over the long term to raise money. The short-run effect
 CHAPTER 3 Working with Financial Statements 57

would be an increase in cash from the issue proceeds and an increase in long-term debt.
Current liabilities would not be affected, so the current ratio would rise.
Finally, note that an apparently low current ratio may not be a bad sign for a company
with a large reserve of untapped borrowing power.

EXAMPLE 3.1 Current Events

Suppose a firm were to pay off some of its suppliers and short-term creditors. What would happen
to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens
if a firm sells some merchandise?
The first case is a trick question. What happens is that the current ratio moves away from 1. If it
is greater than 1 (the usual case), it will get bigger, but if it is less than 1, it will get smaller. To see this,
suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we
use $1 in cash to reduce current liabilities, then the new current ratio is ($4 – 1)/($2 – 1) = 3. If we
reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will
cause the current ratio to fall to 1/3 from 1/2.
The second case is not quite as tricky. Nothing happens to the current ratio because cash
goes down while inventory goes up—total current assets are unaffected.
In the third case, the current ratio would usually rise because inventory is normally shown at
cost, and the sale would normally be at something greater than cost (the difference is the markup).
The increase in either cash or receivables is therefore greater than the decrease in inventory. This
increases current assets, and the current ratio rises.

Quick (or Acid-Test) Ratio Inventory is often the least liquid current asset. It’s also
the one for which the book values are least reliable as measures of market value because
the quality of the inventory isn’t considered. Some of the inventory may later turn out to be
damaged, obsolete, or lost.
More to the point, relatively large inventories are often a sign of short-term trouble.
The firm may have overestimated sales and overbought or overproduced as a result. In this
case, the firm may have a substantial portion of its liquidity tied up in slow-moving
inventory.
To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the cur-
rent ratio, except inventory is omitted:
Current assets − Inventory
Quick ratio = [3.2]
Current liabilities

Notice that using cash to buy inventory does not affect the current ratio, but it reduces the
quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash. For
Prufrock, this ratio in 2016 was:
$708 − 422
Quick ratio = = .53 times
$540

The quick ratio here tells a somewhat different story than the current ratio, because inven-
tory accounts for more than half of Prufrock’s current assets. To exaggerate the point, if
this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for
concern.
To give an example of current versus quick ratios, based on recent financial state-
ments, Walmart and ManpowerGroup, Inc., had current ratios of .88 and 1.49, respectively.
However, Manpower carries no inventory to speak of, whereas Walmart’s current assets are
virtually all inventory. As a result, Walmart’s quick ratio was only .24, whereas Manpow-
er’s was 1.49, the same as its current ratio.
58 PART 2 Understanding Financial Statements and Cash Flow

Cash Ratio A very short-term creditor might be interested in the cash ratio.
Cash
Cash ratio = [3.3]
Current liabilities

You can verify that this works out to be .18 times for Prufrock.

Long-Term Solvency Measures

Long-term solvency ratios are intended to address the firm’s long-run ability to meet its
obligations, or, more generally, its financial leverage. These ratios are sometimes called
financial leverage ratios or just leverage ratios. We consider three commonly used mea-
sures and some variations.

Total Debt Ratio The total debt ratio takes into account all debts of all maturities to
all creditors. It can be defined in several ways, the easiest of which is:
Total assets − Total equity
Total debt ratio = [3.4]
Total assets
$3,588 − 2,591
= = .28 times
$3,588

In this case, an analyst might say that Prufrock uses 28 percent debt.1 Whether this is high
or low or whether it even makes any difference depends on whether or not capital structure
matters, a subject we discuss in a later chapter.
Prufrock has $.28 in debt for every $1 in total assets. Therefore, there is $.72 in equity
(=$1 − .28) for every $.28 in debt. With this in mind, we can define two useful variations
on the total debt ratio, the debt–equity ratio and the equity multiplier:
Debt–equity ratio = Total debt/Total equity [3.5]
= $.28/$.72 = .38 times
Equity multiplier = Total assets/Total equity [3.6]
= $1/$.72 = 1.38 times

The fact that the equity multiplier is 1 plus the debt–equity ratio is not a coincidence:
Equity multiplier = Total assets/Total equity = $1/$.72 = 1.38 times
= (Total equity + Total debt)/Total equity
= 1 + Debt–equity ratio = 1.38 times

The thing to notice here is that given any one of these three ratios, you can immediately
calculate the other two, so they all say exactly the same thing.

Times Interest Earned Another common measure of long-term solvency is the

times interest earned (TIE) ratio. Once again, there are several possible (and common)
definitions, but we’ll stick with the most traditional:
EBIT
Times interest earned ratio = [3.7]
Interest
$691
= = 4.9 times
$141

1
Total equity here includes preferred stock (discussed in Chapter 7), if there is any. An equivalent numerator in
this ratio would be (Current liabilities + Long-term debt).
 CHAPTER 3 Working with Financial Statements 59

As the name suggests, this ratio measures how well a company has its interest obligations
covered, and it is often called the interest coverage ratio. For Prufrock, the interest bill is
covered 4.9 times over.

Cash Coverage A problem with the TIE ratio is that it is based on EBIT, which is not
really a measure of cash available to pay interest. The reason is that depreciation, a noncash
expense, has been deducted out. Because interest is most definitely a cash outflow (to
creditors), one way to define the cash coverage ratio is:
EBIT + Depreciation
Cash coverage ratio = [3.8]
Interest
$691 + 276 $967
= = = 6.9 times
$141 $141

The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before
interest, taxes, and depreciation—say “ebbit-dee”). It is a basic measure of the firm’s abil-
ity to generate cash from operations, and it is frequently used as a measure of cash flow
available to meet financial obligations.
A common variation on EBITD is earnings before interest, taxes, depreciation, and
amortization (EBITDA—say “ebbit-dah”). Here amortization refers to a noncash de-
duction similar conceptually to depreciation, except it applies to an intangible asset
(such as a patent) rather than a tangible asset (such as a machine). Note that the word
amortization here does not refer to the repayment of debt, a subject we discuss in a later
chapter.

Asset Management, or Turnover, Measures

We next turn our attention to the efficiency with which Prufrock uses its assets. The mea-
sures in this section are sometimes called asset utilization ratios. The specific ratios we
discuss can all be interpreted as measures of turnover. What they are intended to describe
is how efficiently, or intensively, a firm uses its assets to generate sales. We first look at
two important current assets: inventory and receivables.

Inventory Turnover and Days’ Sales in Inventory During the year, Prufrock
had a cost of goods sold of $1,344. Inventory at the end of the year was $422. With these
numbers, inventory turnover can be calculated as:
Cost of goods sold
Inventory turnover = [3.9]
Inventory
$1,344
= = 3.2 times
$422

In a sense, we sold off, or turned over, the entire inventory 3.2 times. As long as we are not
running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently
we are managing inventory.
If we know that we turned our inventory over 3.2 times during the year, then we can
immediately figure out how long it took us to turn it over on average. The result is the aver-
age days’ sales in inventory:
365 days
Days’ sales in inventory = [3.10]
Inventory turnover
365
= = 115 days
3.2
60 PART 2 Understanding Financial Statements and Cash Flow

This tells us that, roughly speaking, inventory sits 115 days on average before it is sold.
Alternatively, assuming we used the most recent inventory and cost figures, it will take
about 115 days to work off our current inventory.
For example, in late 2014, the auto industry had a 71-day supply of cars and trucks. Of
course, not all manufacturers had the same inventory level. At that same time, General Mo-
tors had a 94-day supply. This inventory level means that at the then-current rate of sales,
it would have taken General Motors 94 days to deplete the available supply, or, equiva-
lently, that General Motors had 94 days of vehicle sales in inventory. At the same time,
Mitsubishi had a 75-day supply of cars, while Ford had a mere 25-day supply. This type of
information is useful to auto manufacturers in planning future marketing and production
decisions. Historically, a 60-day supply of inventory has been considered normal in the
automobile industry, so these figures pointed to manufacturing continuing at the same
level, or decreasing slightly, in 2015.
It might make more sense to use the average inventory in calculating turnover.
Inventory turnover would then be $l,344/[($393 + 422)/2] = 3.3 times.2 It depends on
the purpose of the calculation. If we are interested in how long it will take us to sell
our current inventory, then using the ending figure (as we did initially) is probably
better.
In many of the ratios we discuss in the following pages, average figures could just as
well be used. Again, it depends on whether we are worried about the past, in which case
averages are appropriate, or the future, in which case ending figures might be better. Also,
using ending figures is common in reporting industry averages; so, for comparison pur-
poses, ending figures should be used in such cases. In any event, using ending figures is
definitely less work, so we’ll continue to use them.

Receivables Turnover and Days’ Sales in Receivables Our inventory mea-

sures give some indication of how fast we can sell products. We now look at how fast we
collect on those sales. The receivables turnover is defined in the same way as inventory
turnover:
Sales
Receivables turnover = [3.11]
Accounts receivable
$2,311
= = 12.3 times
$188

Loosely speaking, we collected our outstanding credit accounts and reloaned the money
12.3 times during the year.3
This ratio makes more sense if we convert it to days, so the days’ sales in receiv-
ables is:
365 days
Days’ sales in receivables = [3.12]
Receivables turnovers
365
= = 30 days
12.3

Therefore, on average, we collect on our credit sales in 30 days. For obvious reasons, this
ratio is very frequently called the average collection period (ACP).

2
Notice that we calculated the average as (Beginning value + Ending value)/2.
3
Here we have implicitly assumed that all sales are credit sales. If they were not, then we would simply use total
credit sales in these calculations, not total sales.
 CHAPTER 3 Working with Financial Statements 61

Also note that if we are using the most recent figures, we can also say that we have
30 days’ worth of sales currently uncollected. We will learn more about this subject when
we study credit policy in a later chapter.

EXAMPLE 3.2 Payables Turnover

Here is a variation on the receivables collection period. How long, on average, does it take for Pru-
frock Corporation to pay its bills? To answer, we need to calculate the accounts payable turnover
rate using cost of goods sold. We will assume that Prufrock purchases everything on credit.
The cost of goods sold is $1,344, and accounts payable are $344. The turnover is therefore
$1,344/$344 = 3.9 times. So, days’ costs in payables was about 365/3.9 = 94 days. On average,
then, Prufrock takes 94 days to pay. As a potential creditor, we might take note of this fact.

Total Asset Turnover Moving away from specific accounts like inventory or receiv-
ables, we can consider an important “big picture” ratio, the total asset turnover ratio. As
the name suggests, total asset turnover is:
Sales
Total asset turnover = [3.13]
Total assets
$2,311
= = .64 times
$3,588

In other words, for every dollar in assets, we generated $.64 in sales.

A closely related ratio, the capital intensity ratio, is simply the reciprocal of (that is, The eXtensible Business
1 divided by) total asset turnover. It can be interpreted as the dollar investment in assets Reporting Language
needed to generate $1 in sales. High values correspond to capital-intensive industries (such (XBRL) is designed to
as public utilities). For Prufrock, total asset turnover is .64, so, if we flip this over, we get make extracting EDGAR
that capital intensity is $l/.64 = $1.56. That is, it takes Prufrock $1.56 in assets to create data easier. You can
learn more about it
$1 in sales.
at www.xbrl.org.
It might seem that a high total asset turnover ratio is always a good sign for a company,
but it isn’t necessarily. Consider a company with old assets. The assets would be almost
fully depreciated and might be very outdated. In this case, the book value of assets is low,
contributing to a higher asset turnover. Plus, the high turnover might mean that the com-
pany will need to make major capital outlays in the near future. A low asset turnover might
seem bad, but it could indicate the opposite: The company could have just purchased a lot
of new equipment, which implies that the book value of assets is relatively high. These new
assets could be more productive and efficient than those used by the company’s
competitors.

EXAMPLE 3.3 More Turnover

Suppose you find that a particular company generates $.40 in sales for every dollar in total assets.
How often does this company turn over its total assets?
The total asset turnover here is .40 times per year. It takes 1/.40 = 2.5 years to turn assets over
completely.

Profitability Measures
The three measures we discuss in this section are probably the best known and most widely
used of all financial ratios. In one form or another, they are intended to measure how
62 PART 2 Understanding Financial Statements and Cash Flow

efficiently the firm uses its assets and how efficiently the firm manages its operations. The
focus in this group is on the bottom line—net income.

Profit Margin Companies pay a great deal of attention to their profit margin:
Net income
Profit margin = [3.14]
Sales
$363
= = 15.7%
$2,311

This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in
profit for every dollar in sales.
All other things being equal, a relatively high profit margin is obviously desirable.
This situation corresponds to low expense ratios relative to sales. However, we hasten to
add that other things are often not equal.
For example, lowering our sales price will usually increase unit volume, but will nor-
mally cause profit margins to shrink. Total profit (or, more importantly, operating cash
flow) may go up or down, so the fact that margins are smaller isn’t necessarily bad. After
all, isn’t it possible that, as the saying goes, “Our prices are so low that we lose money on
everything we sell, but we make it up in volume!”?4

Return on Assets Return on assets (ROA) is a measure of profit per dollar of assets.
It can be defined several ways, but the most common is:
Net income
Return on assets = [3.15]
Total assets
$363
= = 10.1%
$3,588

Return on Equity Return on equity (ROE) is a measure of how the stockholders fared
during the year. Because benefiting shareholders is our goal, ROE is, in an accounting
sense, the true bottom-line measure of performance. ROE is usually measured as:
Net income
Return on assets = [3.16]
Total equity
$363
= = 14.0%
$2,591

Therefore, for every dollar in equity, Prufrock generated 14 cents in profit, but, again, this
is only correct in accounting terms.
Because ROA and ROE are such commonly cited numbers, we stress that it is impor-
tant to remember they are accounting rates of return. For this reason, these measures
should properly be called return on book assets and return on book equity. In addition,
ROE is sometimes called return on net worth. Whatever it’s called, it would be inappropri-
ate to compare the result to, for example, an interest rate observed in the financial
markets.
The fact that ROE exceeds ROA reflects Prufrock’s use of financial leverage. We will
examine the relationship between these two measures in more detail later.

4
No, it’s not; margins can be small, but they do need to be positive!
 CHAPTER 3 Working with Financial Statements 63

Market Value Measures

Our final group of measures is based, in part, on information not necessarily contained in
financial statements—the market price per share of the stock. Obviously, these measures
can be calculated directly only for publicly traded companies.
We assume that Prufrock has 33 million shares outstanding and the stock sold for $88
per share at the end of the year. If we recall that Prufrock’s net income was $363 million,
then we can calculate that its earnings per share were:
Net income $363
EPS = = = $11 [3.17]
Shares outstanding 33

Price–Earnings Ratio The first of our market value measures, the price–earnings,
or PE, ratio (or multiple), is defined as:
Price per share
PE ratio = [3.18]
Earnings per share
$88
= = 8 times
$11
In the vernacular, we would say that Prufrock shares sell for eight times earnings, or we
might say that Prufrock shares have, or “carry,” a PE multiple of 8.
Because the PE ratio measures how much investors are willing to pay per dollar of
current earnings, higher PEs are often taken to mean that the firm has significant prospects
for future growth. Of course, if a firm had no or almost no earnings, its PE would probably
be quite large; so, as always, care is needed in interpreting this ratio.

Price–Sales Ratio In some cases, companies will have negative earnings for extended
periods, so their PE ratios are not very meaningful. A good example is a recent start-up. Such
companies usually do have some revenues, so analysts will often look at the price–sales ratio:
Price–sales ratio = Price per share/Sales per share [3.19]

In Prufrock’s case, sales were $2,311, so here is the price–sales ratio:

Price–sales ratio = $88/($2,311/33) = $88/$70 = 1.26 times

As with PE ratios, whether a particular price–sales ratio is high or low depends on the in-
dustry involved.

Market-to-Book Ratio A second commonly quoted measure is the market-to-book ratio:

Market value per share
Market-to-book ratio = [3.20]
Book value per share
$88 $88
= = = 1.12 times
$2,591/33 $78.5
Notice that book value per share is total equity (not just common stock) divided by the
number of shares outstanding.
Because book value per share is an accounting number, it reflects historical costs.
Therefore, in a loose sense, the market-to-book ratio compares the market value of the
firm’s investments to their cost. A value less than 1 could mean that the firm has not been
successful overall in creating value for its stockholders.

Enterprise Value–EBITDA Ratio A company’s enterprise value is an estimate of

the market value of the company’s operating assets. By operating assets, we mean all the
64 PART 2 Understanding Financial Statements and Cash Flow

assets of the firm except cash. Of course, it’s not practical to work with the individual as-
sets of a firm because market values would usually not be available. Instead, we can use the
right-hand side of the balance sheet and calculate the enterprise value as:
Enterprise value = Total market value of the stock
[3.21]
+ Book value of all liabilities − Cash

We use the book value for liabilities because we typically can’t get the market values, at
least not for all of them. However, book value is usually a reasonable approximation for
market value when it comes to liabilities, particularly short-term debts. Notice that the sum
of the value of the market values of the stock and all liabilities equals the value of the
firm’s assets from the balance sheet identity. Once we have this number, we subtract the
cash to get the enterprise value.
Enterprise value is frequently used to calculate the EBITDA ratio (or multiple):
EBITDA ratio = Enterprise value/EBITDA [3.22]

This ratio is similar in spirit to the PE ratio, but it relates the value of all the operating assets (the
enterprise value) to a measure of the operating cash flow generated by those assets (EBITDA).
This completes our definition of some common ratios. We could tell you about more of
them, but these are enough for now. We’ll leave it here and go on to discuss some ways of
using these ratios instead of just how to calculate them. Table 3.5 summarizes the ratios

T A B L E 3.5 Common financial ratios

I. Short-term solvency, or liquidity, ratios 365 days

Daysʼ sales in receivables =
Current assets Receivables turnover
Current ratio =
Current liabilities 365 days
Daysʼ costs in payables =
Current assets − Inventory Payables turnover
Quick ratio =
Current liabilities Sales
Total asset turnover =
Cash Total assets
Cash ratio =
Current liabilities Total assets
Capital intensity =
II. Long-term solvency, or financial leverage, ratios Sales
Total assets − Total equity IV. Profitability ratios
Total debt ratio = Net income
Total assets Profit margin =
Debt–equity ratio = Total debt/Total equity Sales
Equity multiplier = Total assests/Total equity Net income
Return on assets 1ROA2 =
EBIT Total assets
Times interest earned ratio = Net income
Interest Return on equity 1ROE2 =
EBIT + Depreciation Total equity
Cash coverage ratio = Net income Sales Assets
Interest ROE = × ×
Sales Assets Equity
III. Asset utilization, or turnover, ratios
V. Market value ratios
Cost of goods sold
Inventory turnover = Price per share
Inventory Price–earnings ratio =
Earnings per share
365 days
Daysʼ sales in inventory = Price per share
Inventory turnover Price–sales ratio =
Sales per share
Sales
Receivables turnover = Market value per share
Accounts receivable Market-to-book ratio =
Book value per share
Cost of goods sold
Payables turnover = Enterprise value
Accounts payable EBITDA ratio =
EBITDA
 CHAPTER 3 Working with Financial Statements 65

Lowe’s Home Depot T A B L E 3.6

Sales $56,226 $83,176 Financial information
Net income 2,698 6,345 from 2014 for Lowe’s
Current assets 10,080 15,302 and Home Depot
Current liabilities 9,348 7,488 (numbers in millions
Total assets 31,287 39,946 except for per-share
Total debt 21,589 30,624 data)
Total equity 9,968 9,322
Price per share 67.76 104.43
Book value per share 10.78 7.28
Earnings per share 2.92 4.96
Current ratio 1.08 2.04
Debt–equity ratio 2.19 3.29
Total asset turnover 1.80 2.08
Profit margin 4.80% 7.63%
ROE 27.07% 68.06%
ROA 8.48% 15.88%
Market-to-book ratio 6.29 14.34
Price–earnings ratio 23.23 21.07

we’ve discussed. Table 3.6 provides some information for the well-known home supply
stores Lowe’s and Home Depot for their fiscal years ending in 2014. As you can see, Home
Depot has a slightly higher current ratio, debt–equity ratio, and total asset turnover. Home
Depot also has higher profitability ratios. Because of its increased use of leverage and better
profitability, Home Depot has a higher ROE, something we will discuss in the next section.
The price–earnings ratio is similar for Lowe’s and Home Depot, although Home De-
pot’s market-to-book ratio is almost twice as large as Lowe’s. Overall, Home Depot ap-
pears to be performing better than Lowe’s based on this abbreviated financial analysis. Of
course, if we really want to examine these two companies, we would want to look at more
ratios than the ones presented here.

CONCE P T Q U ES T I O N S
3.2a What are the five groups of ratios? Give two or three examples of each kind.
3.2b Turnover ratios all have one of two figures as numerators. What are these two
figures? What do these ratios measure? How do you interpret the results?
3.2c Profitability ratios all have the same figure in the numerator. What is it? What do
these ratios measure? How do you interpret the results?
3.2d Given the total debt ratio, what other two ratios can be computed? Explain how.

3.3 THE DUPONT IDENTITY

As we mentioned in discussing ROA and ROE, the difference between these two profit- Excel
ability measures is a reflection of the use of debt financing, or financial leverage. We Master
coverage online
illustrate the relationship between these measures in this section by investigating a famous
way of decomposing ROE into its component parts.
66 PART 2 Understanding Financial Statements and Cash Flow

To begin, let’s recall the definition of ROE:

Net income
Return on equity =
Total equity

If we were so inclined, we could multiply this ratio by Assets/Assets without changing

anything:
Net income Net income Assets
Return on equity = = ×
Total equity Total equity Assets
Net income Assets
= ×
Assets Total equity

Notice that we have expressed the ROE as the product of two other ratios—ROA and the
equity multiplier:
ROE = ROA × Equity multiplier = ROA × (1 + Debt–equity ratio)

Looking back at Prufrock, for example, we see that the debt–equity ratio was .38 and ROA
was 10.1 percent. Our work here implies that Prufrock’s ROE, as we previously calculated, is:
ROE = 10.1% × 1.38 = 14%

We can further decompose ROE by multiplying the top and bottom by total sales:
Sales Net income Assets
ROE = × ×
Sales Assets Total equity

If we rearrange things a bit, ROE is:

Net income Sales Assets
ROE = × ×
Sales Assets Total equity
[3.23]
w

Return on assets

= Profit margin × Total asset turnover × Equity multiplier

What we have now done is to partition ROA into its two component parts, profit margin
DuPont identity and total asset turnover. This last expression is called the DuPont identity, after the DuPont
Popular expression Corporation, which popularized its use.
breaking ROE into three We can check this relationship for Prufrock by noting that the profit margin was
parts: operating efficiency,
15.7 percent and the total asset turnover was .64. ROE should thus be:
asset use efficiency, and
financial leverage.
ROE = Profit margin × Total asset turnover × Equity multiplier
= .157 × .64 × 1.38
= .14, or 14%

This 14 percent ROE is exactly what we had before.

The DuPont identity tells us that ROE is affected by three things:
1. Operating efficiency (as measured by profit margin).
2. Asset use efficiency (as measured by total asset turnover).
3. Financial leverage (as measured by the equity multiplier).
Weakness in either operating or asset use efficiency (or both) will show up in a diminished
return on assets, which will translate into a lower ROE.
Considering the DuPont identity, it appears that a firm could leverage up its ROE by
increasing its amount of debt. It turns out this will only happen if the ratio of EBIT to total
assets is greater than the interest rate. More importantly, the use of debt financing has a
 CHAPTER 3 Working with Financial Statements 67

Yahoo! T A B L E 3.7
Year ROE = Profit margin × Total asset turnover × Equity multiplier DuPont analysis for
2014 .4% = 3.1% × .075 × 1.60
Yahoo! and Google
2013 4.5% = 12.6% × .279 × 1.29
2012 3.9% = 11.4% × .292 × 1.17

Google

Year ROE = Profit margin × Total asset turnover × Equity multiplier

2014 13.8% = 21.9% × .503 × 1.25
2013 15.3% = 24.0% × .501 × 1.27
2012 16.1% = 25.1% × .491 × 1.31

number of other effects, and, as we discuss at some length in later chapters, the amount of
leverage a firm uses is governed by its capital structure policy.
The decomposition of ROE we’ve discussed in this section is a convenient way of
systematically approaching financial statement analysis. If ROE is unsatisfactory by some
measure, then the DuPont identity tells you where to start looking for the reasons. To give
an example, take a look at the information about Internet companies Yahoo! and Google in
Table 3.7. As you can see, in 2014, Yahoo! had an ROE of .4 percent, down from its ROE
in 2012 of 3.9 percent. In contrast, also in 2014, Google had an ROE of 13.8 percent, down
from its ROE in 2012 of 16.1 percent. Given this information, why is Google’s ROE so
much higher than Yahoo!’s over this period of time?
Looking at the DuPont breakdown, we see that Yahoo!’s profit margin decreased dra-
matically, from 11.4 percent to 3.1 percent. Google’s profit margin was 21.9 percent in
2014, also a decrease from the level two years before. Google’s total asset turnover re-
mained constant, while Yahoo!’s fell dramatically. Finally, Google’s leverage was almost
constant, while Yahoo!’s increased.
Yahoo!’s ROE fell because of the sharp decline in profit margin and total asset
turnover. Even though the equity multiplier increased, the increase was not enough to
offset the effect of the profit margin and total asset turnover declines. The most no-
ticeable differences between the companies are Google’s much higher profit margin
and total asset turnover, suggesting that Google is able to generate revenues at a far
lower cost than Yahoo! and use its assets more efficiently, which results in a much
higher ROE.

An Expanded DuPont Analysis

So far, we’ve seen how the DuPont equation lets us break down ROE into its basic three The regulatory filings of
components: profit margin, total asset turnover, and financial leverage. We now extend this publicly traded
analysis to take a closer look at how key parts of a firm’s operations feed into ROE. To get corporations may be found
going, we went to the SEC website (www.sec.gov) and found the 10-K for chemical prod- at www.sec.gov.
ucts giant DuPont. In the 10-K, we located the financial statements for 2014. What we
found is summarized in Table 3.8.
Using the information in Table 3.8, Figure 3.1 shows how we can construct an ex-
panded DuPont analysis for DuPont and present that analysis in chart form. The advantage
of the extended DuPont chart is that it lets us examine several ratios at once, thereby get-
ting a better overall picture of a company’s performance and also allowing us to determine
possible items to improve.
68 PART 2 Understanding Financial Statements and Cash Flow

T A B L E 3.8

FINANCIAL STATEMENTS FOR DUPONT

12 months ending December 31, 2014
(All numbers are in millions)

Income Statement Balance Sheet

Sales $35,553 Current assets Current liabilities
CoGS 21,703 Cash $ 7,034 Accounts payable $11,217
Gross profit $13,850 Accounts receivable 6,594 Notes payable 1,423
SG&A expense 6,411 Inventory 8,120 Total $12,640
R&D expense 2,067 Total $21,748 Total long-term debt $23,916
EBIT $ 5,372 Fixed assets $28,128 Total equity $13,320
Interest 377 Total assets $49,876 Total liabilities and equity $49,876
EBT $ 4,995
Taxes 1,370
Net income $ 3,625

F I G U R E 3.1 Extended DuPont chart for DuPont

Return on
equity
27.21%

Return on Equity
Multiplied
assets multiplier
by
7.27% 3.74

Total asset
Profit margin
Multiplied by turnover
10.20%
.71

Net income Sales Sales Total assets

Divided by Divided by
$3,625 $35,553 $35,553 $49,876

Total costs Subtracted Sales Fixed assets Plus Current assets

$31,928 from $35,553 $28,128 $21,748

Cash
Cost of goods
R&D $7,034
sold
$21,703 $2,067

Accounts
Selling, gen. & Inventory
receivable
admin. expense Interest $8,120
$6,594
$6,411 $377

Taxes
$1,370
 CHAPTER 3 Working with Financial Statements 69

Looking at the left-hand side of our DuPont chart in Figure 3.1, we see items related
to profitability. As always, profit margin is calculated as net income divided by sales. But,
as our chart emphasizes, net income depends on sales and a variety of costs, such as cost of
goods sold (CoGS) and selling, general, and administrative expenses (SG&A expense).
DuPont can increase its ROE by increasing sales and also by reducing one or more of these
costs. In other words, if we want to improve profitability, our chart clearly shows us the
areas on which we should focus.
Turning to the right-hand side of Figure 3.1, we have an analysis of the key factors
underlying total asset turnover. Thus, for example, we see that reducing inventory holdings
through more efficient management reduces current assets, which reduces total assets,
which then improves total asset turnover.

CONCE P T Q U ES T I O N S
3.3a Return on assets, or ROA, can be expressed as the product of two ratios. Which two?
3.3b Return on equity, or ROE, can be expressed as the product of three ratios. Which three?

3.4 INTERNAL AND SUSTAINABLE GROWTH

A firm’s return on assets and return on equity are frequently used to calculate two addi-
tional numbers, both of which have to do with the firm’s ability to grow. We examine these
next, but first we introduce two basic ratios.

Dividend Payout and Earnings Retention

As we have seen in various places, a firm’s net income gets divided into two pieces. The You can find growth rates
first piece is cash dividends paid to stockholders. Whatever is left over is the addition to under the “Key Statistics”
retained earnings. For example, from Table 3.3, Prufrock’s net income was $363, of which link at finance.yahoo.com.
$121 was paid out in dividends. If we express dividends paid as a percentage of net in-
come, the result is the dividend payout ratio:
Dividend payout ratio = Cash dividends/Net income [3.24]
= $121/$363
= 33⅓%

What this tells us is that Prufrock pays out one-third of its net income in dividends.
Anything Prufrock does not pay out in the form of dividends must be retained in the
firm, so we can define the retention ratio as:
Retention ratio = Addition to retained earnings/Net income [3.25]
= $242/$363
= 66⅔%
So, Prufrock retains two-thirds of its net income. The retention ratio is also known as the
plowback ratio because it is, in effect, the portion of net income that is plowed back into
the business.
Notice that net income must be either paid out or plowed back, so the dividend payout
and plowback ratios have to add up to 1. Put differently, if you know one of these figures,
you can figure the other one out immediately.
70 PART 2 Understanding Financial Statements and Cash Flow

EXAMPLE 3.4 Payout and Retention

The Manson-Marilyn Corporation routinely pays out 40 percent of net income in the form of
dividends. What is its plowback ratio? If net income was $800, how much did stockholders actu-
ally receive?
If the payout ratio is 40 percent, then the retention, or plowback, ratio must be 60 percent
because the two have to add up to 100 percent. Dividends were 40 percent of $800, or $320.

ROA, ROE, and Growth

Investors and others are frequently interested in knowing how rapidly a firm’s sales can
grow. The important thing to recognize is that if sales are to grow, assets have to grow as
well, at least over the long run. Further, if assets are to grow, then the firm must somehow
obtain the money to pay for the needed acquisitions. In other words, growth has to be fi-
nanced, and as a direct corollary, a firm’s ability to grow depends on its financing policies.
A firm has two broad sources of financing: internal and external. Internal financ-
ing simply refers to what the firm earns and subsequently plows back into the business.
External financing refers to funds raised by either borrowing money or selling stock.
The Internal Growth Rate Suppose a firm has a policy of financing growth using
only internal financing. This means that the firm won’t borrow any funds and won’t sell any
internal growth rate new stock. How rapidly can the firm grow? The answer is given by the internal growth rate:
The maximum possible
growth rate a firm can ROA × b
Internal growth rate = [3.26]
achieve without external 1 − ROA × b
financing of any kind.
where ROA is, as usual, return on assets, and b is the retention, or plowback, ratio we just
discussed.
For example, for the Prufrock Corporation, we earlier calculated ROA as 10.12 percent.
We also saw that the retention ratio is 66 2⁄3 percent, or 2⁄3, so the internal growth rate is:
ROA × b
Internal growth rate =
1 − ROA × b
.1012 × ⅔
=
1 − .1012 × ⅔
= 7.23%

Thus, if Prufrock relies solely on internally generated financing, it can grow at a maximum
rate of 7.23 percent per year.
The Sustainable Growth Rate If a firm only relies on internal financing, then,
through time, its total debt ratio will decline. The reason is that assets will grow, but total
debt will remain the same (or even fall if some is paid off). Frequently, firms have a par-
ticular total debt ratio or equity multiplier that they view as optimal (why this is so is the
subject of Chapter 13).
With this in mind, we now consider how rapidly a firm can grow if (1) it wishes to
maintain a particular total debt ratio and (2) it is unwilling to sell new stock. There are vari-
sustainable growth ous reasons a firm might wish to avoid selling stock, and equity sales by established firms
rate are actually a relatively rare occurrence. Given these two assumptions, the maximum
The maximum possible
growth rate that can be achieved, called the sustainable growth rate, is:
growth rate a firm can
achieve without external ROE × b
equity financing while Sustainable growth rate = [3.27]
1 − ROE × b
maintaining a constant
debt–equity ratio. Notice that this is the same as the internal growth rate, except that ROE is used instead of ROA.
 CHAPTER 3 Working with Financial Statements 71

Looking at Prufrock, we earlier calculated ROE as 14 percent, and we know that the
retention ratio is ⅔, so we can easily calculate sustainable growth as:
ROE × b
Sustainable growth rate =
1 − ROE × b
.14 × ⅔
=
1 − .14 × ⅔
= 10.29%

If you compare this sustainable growth rate of 10.29 percent to the internal growth rate of
7.23 percent, you might wonder why it is larger. The reason is that, as the firm grows, it
will have to borrow additional funds if it is to maintain a constant debt ratio. This new bor-
rowing is an extra source of financing in addition to internally generated funds, so Prufrock
can expand more rapidly.

Determinants of Growth In our previous section, we saw that the return on equity,
or ROE, could be decomposed into its various components using the DuPont identity. Be-
cause ROE appears so prominently in the determination of the sustainable growth rate, the
factors important in determining ROE are also important determinants of growth.
As we saw, ROE can be written as the product of three factors:
ROE = Profit margin × Total asset turnover × Equity multiplier

If we examine our expression for the sustainable growth rate, we see that anything that in-
creases ROE will increase the sustainable growth rate by making the top bigger and the
bottom smaller. Increasing the plowback ratio will have the same effect.
Putting it all together, what we have is that a firm’s ability to sustain growth depends
explicitly on the following four factors:
1. Profit margin. An increase in profit margin will increase the firm’s ability to generate
funds internally and thereby increase its sustainable growth.
2. Total asset turnover. An increase in the firm’s total asset turnover increases the
sales generated for each dollar in assets. This decreases the firm’s need for new
assets as sales grow and thereby increases the sustainable growth rate. Notice
that increasing total asset turnover is the same thing as decreasing capital
intensity.
3. Financial policy. An increase in the debt–equity ratio increases the firm’s financial
leverage. Because this makes additional debt financing available, it increases the
sustainable growth rate.
4. Dividend policy. A decrease in the percentage of net income paid out as dividends
will increase the retention ratio. This increases internally generated equity and thus
increases internal and sustainable growth.
The sustainable growth rate is a very useful number. What it illustrates is the explicit
relationship between the firm’s four major areas of concern: its operating efficiency as
measured by profit margin, its asset use efficiency as measured by total asset turnover, its
financial policy as measured by the debt–equity ratio, and its dividend policy as measured
by the retention ratio. If sales are to grow at a rate higher than the sustainable growth rate,
the firm must increase profit margins, increase total asset turnover, increase financial
leverage, increase earnings retention, or sell new shares.
The two growth rates, internal and sustainable, are summarized in Table 3.9. The
nearby Finance Matters box discusses some issues related to growth rates.
FINANCE M AT T E RS

How Fast Is Too Fast?

G rowth rates are an important tool for evaluating a com-
pany, and, as we will see later, an important tool for
valuing a company’s stock. When thinking about (and calcu-
which exceeds the gross domestic product (GDP) of the
United States. Obviously, Facebook’s growth rate will slow
substantially in the next several years.
lating) growth rates, a little common sense goes a long way. What about growth in cash flow? As of the beginning
For example, in 2014, retailing giant Walmart had about of 2015, cash flow for Internet travel booking website
1.1 billion square feet of stores, distribution centers, and so Priceline.com grew at an annual rate of about 40 percent
forth. The company expected to expand its square footage for the past five years. The company generated about
by a little less than 4 percent over the next year. This in- $2.95 billion in cash flow for 2014. If Priceline.com’s cash
crease doesn’t sound too outrageous, but can Walmart grow flow grew at the same rate for the next 18 years, the com-
its square footage at 4 percent indefinitely? pany would generate about $1.26 trillion dollars per year, or
We’ll get into the calculation in our next chapter, but if just slightly less than the $1.34 trillion of U.S. currency circu-
you assume that Walmart grows at 4 percent per year over lating in the world.
the next 292 years, the company will have about 100 trillion As these examples show, growth rates can be deceiv-
square feet of property, which is about the total land mass of ing. It is fairly easy for a small company to grow very fast. If a
the entire United States! In other words, if Walmart keeps company has $100 dollars in sales, it only has to increase
growing at 4 percent, the entire country will eventually be sales by another $100 to have a 100 percent increase in
one big Walmart. Scary. sales. If the company’s sales are $10 billion, it has to increase
Facebook is another example. The company had total sales by another $10 billion to achieve the same 100 percent
revenues of about $1.97 billion in 2010 and $12.47 billion in increase. So, long-term growth rate estimates must be cho-
2014. This represents an annual rate of increase of 59 per- sen very carefully. As a rule of thumb, for really long-term
cent! How likely do you think it is that the company can con- growth estimates, you should probably assume that a com-
tinue this growth rate? If this growth continued, the company pany will not grow much faster than the economy as a
would have revenues of about $19.83 trillion in just 16 years, whole, which is about 1 to 3 percent (inflation-adjusted).

T A B L E 3.9 I. Internal growth rate

ROA × b
Summary of internal Internal growth rate =
1 − ROA × b
and sustainable where
growth rates
ROA = Return on assets = Net income/Total assets
b = Plowback (retention) ratio
= Addition to retained earnings/Net income
= 1 – Dividend payout ratio
The internal growth rate is the maximum growth rate that can be achieved with no external
financing of any kind.
II. Sustainable growth rate
ROE × b
Sustainable growth rate =
1 − ROE × b
where
ROE = Return on equity = Net income/Total equity
b = Plowback (retention) ratio
= Addition to retained earnings/Net income
= 1 – Dividend payout ratio
The sustainable growth rate is the maximum growth rate that can be achieved with no
external equity financing while maintaining a constant debt–equity ratio.

72
 CHAPTER 3 Working with Financial Statements 73

A Note on Sustainable Growth Rate Calculations Very commonly, the sus-

tainable growth rate is calculated using just the numerator in our expression, ROE × b.
This causes some confusion, which we can clear up here. The issue has to do with how
ROE is computed. Recall that ROE is calculated as net income divided by total equity. If
total equity is taken from an ending balance sheet (as we have done consistently, and is
commonly done in practice), then our formula is the right one. However, if total equity is
from the beginning of the period, then the simpler formula is the correct one.
In principle, you’ll get exactly the same sustainable growth rate regardless of which way
you calculate it (as long as you match up the ROE calculation with the right formula). In real-
ity, you may see some differences because of accounting-related complications. By the way,
if you use the average of beginning and ending equity (as some advocate), yet another for-
mula is needed. Also, all of our comments here apply to the internal growth rate as well.
A simple example is useful to illustrate these points. Suppose a firm has a net income
of $20 and a retention ratio of .60. Beginning assets are $100. The debt–equity ratio is .25,
so beginning equity is $80.
If we use beginning numbers, we get the following:
ROE = $20/80 = .25 = 25%
Sustainable growth = .25 × .60 = .15 = 15%

For the same firm, ending equity is $80 + .60 × $20 = $92. So, we can calculate this:
ROE = $20/92 = .2174 = 21.74%
Sustainable growth = .2174 × .60/(1 − .2174 × .60) = .15 = 15%

These growth rates are exactly the same (after accounting for a small rounding error in the
second calculation). See if you don’t agree that the internal growth rate is 12%.

CONCE P T Q U ES T I O N S
3.4a What does a firm’s internal growth rate tell us?
3.4b What does a firm’s sustainable growth rate tell us?
3.4c Why is the sustainable growth rate likely to be larger than the internal growth rate?

3.5 USING FINANCIAL STATEMENT INFORMATION

Our last task in this chapter is to discuss in more detail some practical aspects of financial Excel
statement analysis. In particular, we will look at reasons for doing financial statement anal- Master
coverage online
ysis, how to go about getting benchmark information, and some of the problems that come
up in the process.

Why Evaluate Financial Statements?

As we have discussed, the primary reason for looking at accounting information is that we
don’t have, and can’t reasonably expect to get, market value information. It is important to
emphasize that, whenever we have market information, we will use it instead of account-
ing data. Also, if there is a conflict between accounting and market data, market data
should be given precedence.
Financial statement analysis is essentially an application of “management by excep-
tion.” In many cases, such analysis will boil down to comparing ratios for one business
74 PART 2 Understanding Financial Statements and Cash Flow

with some kind of average or representative ratios. Those ratios that seem to differ the most
from the averages are tagged for further study.

Internal Uses Financial statement information has a variety of uses within a firm.
Among the most important of these is performance evaluation. For example, managers are
frequently evaluated and compensated on the basis of accounting measures of performance
such as profit margin and return on equity. Also, firms with multiple divisions frequently
compare the performance of those divisions using financial statement information.
Another important internal use of financial statement information involves planning for
the future. Historical financial statement information is very useful for generating projections
about the future and for checking the realism of assumptions made in those projections.

External Uses Financial statements are useful to parties outside the firm, including
short-term and long-term creditors and potential investors. For example, we would find such
information quite useful in deciding whether or not to grant credit to a new customer.
We would also use this information to evaluate suppliers, and suppliers would use our
statements before deciding to extend credit to us. Large customers use this information to
decide if we are likely to be around in the future. Credit-rating agencies rely on financial
statements in assessing a firm’s overall creditworthiness. The common theme here is that
financial statements are a prime source of information about a firm’s financial health.
We would also find such information useful in evaluating our main competitors. We
might be thinking of launching a new product. A prime concern would be whether the
competition would jump in shortly thereafter. In this case, we would be interested in our
competitors’ financial strength to see if they could afford the necessary development.
Finally, we might be thinking of acquiring another firm. Financial statement informa-
tion would be essential in identifying potential targets and deciding what to offer.

Choosing a Benchmark
Given that we want to evaluate a division or a firm based on its financial statements, a ba-
sic problem immediately comes up. How do we choose a benchmark, or a standard of
comparison? We describe some ways of getting started in this section.

Time-Trend Analysis One standard we could use is history. Suppose we found that
the current ratio for a particular firm is 2.4 based on the most recent financial statement
information. Looking back over the last 10 years, we might find that this ratio has declined
fairly steadily over that period.
Based on this, we might wonder if the liquidity position of the firm has deteriorated. It
could be, of course, that the firm has made changes that allow it to use its current assets
more efficiently, that the nature of the firm’s business has changed, or that business prac-
tices have changed. If we investigate, we might find any of these possible explanations.
This is an example of what we mean by management by exception—a deteriorating time
trend may not be bad, but it does merit investigation.

Peer Group Analysis The second means of establishing a benchmark is to identify

firms similar in the sense that they compete in the same markets, have similar assets, and
Standard Industrial operate in similar ways. In other words, we need to identify a peer group. There are obvi-
Classification (SIC) ous problems with doing this since no two companies are identical. Ultimately, the choice
codes
of which companies to use as a basis for comparison is subjective.
U.S. government code
used to classify a firm by One common way of identifying potential peers is based on Standard Industrial Classification
its type of business (SIC) codes. These are four-digit codes established by the U.S. government for statistical reporting
operations. purposes. Firms with the same SIC code are frequently assumed to be similar.
 CHAPTER 3 Working with Financial Statements 75

Agriculture, Forestry, and Fishing Retail Trade T A B L E 3.10

01 Agriculture production—crops 54 Food stores
02 Forestry 55 Auto dealers and gas stations Selected two-digit
Mining 58 Eating and drinking places SIC codes
10 Metal mining Finance, Insurance, and Real Estate
13 Oil and gas extraction 60 Banking
Construction 63 Insurance
15 Building construction 65 Real Estate
16 Construction other than building Services
Manufacturing 78 Motion pictures
28 Chemicals and allied products 80 Health services
29 Petroleum refining 82 Educational services
35 Machinery, except electrical
37 Transportation equipment
Transportation, Communication, Electric, Gas,
and Sanitary Service
45 Transportation by air
49 Electric, gas, and sanitary services

The first digit in an SIC code establishes the general type of business. For example,
firms engaged in finance, insurance, and real estate have SIC codes beginning with 6. Each
additional digit narrows down the industry. So, companies with SIC codes beginning with
60 are mostly banks and banklike businesses; those with codes beginning with 602 are
mostly commercial banks; and SIC code 6025 is assigned to national banks that are mem-
bers of the Federal Reserve system. Table 3.10 is a list of selected two-digit codes (the first
two digits of the four-digit SIC codes) and the industries they represent.
Beginning in 1997, a new industry classification system was instituted. Specifically, Learn more about NAICS
the North American Industry Classification System (NAICS, pronounced “nakes”) is in- at www.naics.com.
tended to replace the older SIC codes, and it probably will eventually. Currently, however,
SIC codes are widely used.
SIC codes are far from perfect. For example, suppose you were examining financial
statements for Walmart, the largest retailer in the United States. In a quick scan of the near-
est financial database, you might find about 20 large, publicly owned corporations with
this same SIC code, but you might not be too comfortable with some of them. Target would
seem to be a reasonable peer, but Neiman-Marcus also carries the same industry code. Are
Walmart and Neiman-Marcus really comparable?
As this example illustrates, it is probably not appropriate to blindly use SIC code-
based averages. Instead, analysts often identify a set of primary competitors and then com-
pute a set of averages based on just this group. Also, we may be more concerned with a
group of the top firms in an industry, not the average firm. Such a group is called an aspi-
rant group, because we aspire to be like them. In this case, a financial statement analysis
reveals how far we have to go.
We can now take a look at a specific industry. Suppose we are in the retail hardware
business. Table 3.11 contains some condensed common-size financial statements for this
industry from RMA, one of many sources of such information. Table 3.12 contains se-
lected ratios from the same source.
There is a large amount of information here, most of which is self-explanatory. On
the right in Table 3.11, we have current information reported for different groups
based on sales. Within each sales group, common-size information is reported. For
example, firms with sales in the $10 million to $25 million range have cash and equiv-
alents equal to 6.5 percent of total assets. There are 36 companies in this group, out of
369 in all.
76 PART 2 Understanding Financial Statements and Cash Flow

T A B L E 3.11 Selected financial statement information

RETAIL—Hardware Stores NAICS 444130

Comparative Historical Data Current Data Sorted by Sales

Type of Statement
12 6 10 Unqualified 1 2 7
33 48 33 Reviewed 4 3 5 16 5
83 64 88 Compiled 6 37 14 20 7 4
106 121 134 Tax Returns 29 63 15 25 2
103 98 104 Other 14 39 22 12 9 8
43 (4/1–9/30/10) 326 (10/1/10–3/31/11)
4/1/08– 4/1/09– 4/1/10–
3/31/09 3/31/10 3/31/11 0-1 25MM
ALL ALL ALL NUMBER OF MM 1-3MM 3-5MM 5-10MM 10-25MM & OVER
337 337 369 STATEMENTS 49 143 54 63 36 24
Assets
6.4% 7.2% 6.8% Cash & Equivalents 7.0% 7.1% 6.7% 7.3% 6.5% 3.4%
10.3 10.0 8.5 Trade Receivables (net) 7.3 6.6 9.6 10.1 11.8 11.1
53.7 51.0 53.1 Inventory 55.7 55.3 47.6 52.8 48.2 54.7
2.6 1.7 2.1 All Other Current 1.2 2.1 3.0 1.6 2.5 2.2
73.0 69.9 70.4 Total Current 71.1 71.1 67.0 71.8 69.0 71.3
14.4 15.3 15.0 Fixed Assets (net) 12.9 13.7 17.4 15.1 15.9 20.0
2.3 3.9 2.7 Intangibles (net) 1.6 3.0 2.4 2.9 3.1 3.5
10.2 10.9 11.8 All Other Non-Current 14.3 12.2 13.2 10.3 12.0 5.2
100.0 100.0 100.0 Total 100.0 100.0 100.0 100.0 100.0 100.0
Liabilities
12.1 8.9 8.4 Notes Payable-Short Term 6.4 8.6 8.5 6.4 9.9 14.7
3.0 3.5 2.8 Cur. Mat.-L.T.D. 3.0 2.8 3.1 2.4 2.6 2.9
13.2 12.0 12.9 Trade Payables 13.4 11.2 13.2 14.8 11.9 18.6
.1 .2 .1 Income Taxes Payable .2 .1 .1 .1 .3 .0
7.0 6.5 6.9 All Other Current 6.5 7.2 7.1 7.2 5.3 7.6
35.4 30.9 31.2 Total Current 29.5 29.9 31.9 31.0 30.0 43.8
19.8 22.7 21.0 Long-Term Debt 33.8 23.1 20.3 15.3 13.2 11.4
.1 .1 .1 Deferred Taxes .0 .0 .1 .1 .3 .3
7.8 9.5 11.5 All Other Non-Current 27.4 12.5 4.0 7.5 8.1 5.3
36.9 36.7 36.1 Net Worth 9.2 34.5 43.6 46.2 48.4 39.2
100.0 100.0 100.0 Total Liabilities & Net Worth 100.0 100.0 100.0 100.0 100.0 100.0
Income Data
100.0 100.0 100.0 Net Sales 100.0 100.0 100.0 100.0 100.0 100.0
36.4 38.9 38.0 Gross Profit 41.4 38.7 39.7 34.7 36.3 34.2
34.7 37.2 36.4 Operating Expenses 42.8 37.0 37.2 32.4 34.5 32.2
1.7 1.7 1.6 Operating Profit −1.4 1.7 2.6 2.3 1.8 2.0
.0 .0 −.2 All Other Expenses (net) −.7 −.1 −.2 −.3 −.2 .6
1.7 1.8 1.8 Profit Before Taxes −.7 1.8 2.7 2.7 2.1 1.4
M = $ thousand; MM = $ million.
Interpretation of Statement Studies Figures: RMA cautions that the studies be regarded only as a general guideline and not as an absolute industry
norm. This is due to limited samples within categories, the categorization of companies by their primary NAICS code only, and different methods of
operations by companies within the same industry. For these reasons, RMA recommends that the figures be used only as general guidelines in
addition to other methods of financial analysis.
© 2012 by RMA. All rights reserved. No part of this table may be reproduced or utilized in any form or by any means, electronic or mechanical,
including photocopying, recording, or by any information storage and retrieval system, without permission in writing from RMA—Risk Management
Association.
 CHAPTER 3 Working with Financial Statements 77

T A B L E 3.12 Selected ratios

Retail—Hardware Stores NAICS 444130

Comparative Historical Data Current Data Sorted by Sales

Type of
Statement
12 6 10 Unqualified 1 2 7
33 48 33 Reviewed 4 3 5 16 5
83 64 88 Compiled 6 37 14 20 7 4
106 121 134 Tax Returns 29 63 15 25 2
103 98 104 Other 14 39 22 12 9 8
43 (4/1–9/30/10) 326 (10/1/10–3/31/11)
4/1/08– 4/1/09– 4/1/10–
3/31/09 3/31/10 3/31/11 25 MM &
ALL ALL ALL NUMBER OF 0–1 MM 1–3 MM 3–5 MM 5–10 MM 10–25 MM OVER
337 337 369 STATEMENTS 49 143 54 63 36 24
Ratios
4.2 4.9 4.5 5.4 5.0 4.5 4.3 4.4 2.5
2.6 2.8 2.8 Current 2.4 3.5 2.7 2.6 2.9 1.6
1.6 1.6 1.6 1.6 1.8 1.6 1.8 1.5 1.4
1.0 1.1 1.0 1.2 1.0 1.0 1.2 1.2 .5
.5 .5 .5 Quick .5 .5 .4 .6 .6 .2
.2 .2 .2 .1 .2 .3 .2 .3 .1
4 81.5 5 78.7 4 98.1 2 146.6 3 114.4 5 80.2 4 99.2 5 79.6 4 85.4
Sales/
9 39.4 10 36.7 8 45.6 10 35.8 7 50.4 8 43.7 9 41.8 9 39.3 13 27.8
Receivables
22 16.4 20 18.0 18 19.9 17 21.8 13 28.3 23 15.7 27 13.5 24 15.5 20 18.7
94 3.9 95 3.8 100 3.6 116 3.2 110 3.3 94 3.9 87 4.2 66 5.5 90 4.1
Cost of Sales/
138 2.7 141 2.6 141 2.6 191 1.9 160 2.3 121 3.0 123 3.0 118 3.1 134 2.7
Inventory
185 2.0 200 1.8 187 1.9 297 1.2 207 1.8 169 2.2 153 2.4 172 2.1 168 2.2
14 26.4 14 26.6 15 24.2 10 35.4 12 30.5 16 23.1 16 23.3 15 24.0 26 13.8
Cost of Sales/
24 15.0 24 15.4 26 13.9 33 11.1 22 16.4 26 13.8 26 14.3 23 15.9 37 9.9
Payables
38 9.5 37 9.8 43 8.4 88 4.2 37 9.8 45 8.1 44 8.3 36 10.1 47 7.7
3.8 3.7 3.7 3.1 3.5 4.0 4.4 4.1 6.7
Sales/Working
5.6 5.5 5.4 4.2 4.5 6.2 6.1 6.0 8.5
Capital
10.5 9.2 10.1 9.4 8.6 10.0 11.6 12.5 17.4
6.5 6.7 6.6 5.1 6.0 10.2 7.2 7.1 7.8
(306) 2.4 (295) 2.6 (336) 3.0 EBIT/Interest (44) 1.6 (127) 3.0 (49) 3.8 (58) 3.3 (34) 3.2 2.2
.9 .5 1.0 −1.4 .7 1.2 1.7 1.9 .7
4.1 4.2 5.5 Net Profit + Depr., 4.7
(54) 1.7 (50) 1.6 (44) 1.6 Dep., Amort./ (11) 1.4
.4 .5 .4 Cur. Mat. L/T/D .9

.1 .1 .1 .1 .1 .1 .1 .1 .2
.3 .3 .3 Fixed/Worth .6 .3 .3 .2 .2 .4
1.1 1.6 1.1 −.8 3.3 .7 .6 .7 1.0
.6 .6 .6 .9 .5 .4 .6 .6 1.0
1.6 1.7 1.5 Debt/Worth 5.9 1.5 1.3 1.0 1.2 1.8
4.6 7.3 5.6 −14.5 32.4 3.0 3.2 2.4 3.5
25.4 26.9 23.9 % Profit Before 20.9 21.1 42.3 34.7 16.1 15.6
(289) 12.2 (280) 11.0 (311) 11.2 Taxes/Tangible (30) 9.4 (112) 11.2 (50) 13.2 (61) 12.5 (35) 8.4 (23) 12.6
1.5 1.9 2.1 Net Worth .4 .8 2.2 3.5 3.1 −.1

(continued!)
78 PART 2 Understanding Financial Statements and Cash Flow

T A B L E 3.12 Selected ratios (continued!)

43 (4/1–9/30/10) 326 (10/1/10–3/31/11)
4/1/08– 4/1/09– 4/1/10–
3/31/09 3/31/10 3/31/11 25 MM &
ALL ALL ALL NUMBER OF 0–1 MM 1–3 MM 3–5 MM 5–10 MM 10–25 MM OVER
337 337 369 STATEMENTS 49 143 54 63 36 24
9.8 9.9 9.9 % Profit 9.5 9.0 13.3 12.2 6.8 8.1
4.2 4.1 4.1 Before Taxes/ 2.8 4.4 6.1 4.8 3.5 2.4
−.2 −.5 .0 Total Assets −3.9 −1.1 .3 1.3 1.1 −.9
73.0 56.5 64.1 79.7 68.6 61.1 49.3 33.5 37.2
Sales/Net
26.0 24.4 25.3 31.4 26.1 17.7 25.3 23.1 21.6
Fixed Assets
10.2 9.7 9.8 9.8 9.5 8.7 12.4 10.2 9.2
3.0 2.9 2.8 2.4 2.8 3.0 3.0 3.0 2.8
Sales/Total
2.4 2.2 2.3 1.9 2.3 2.3 2.5 2.3 2.6
Assets
1.8 1.7 1.7 1.3 1.7 1.7 2.0 1.9 1.7
.6 .6 .7 % Depr., .8 .7 .7 .5 .8 .7
(269) 1.2 (270) 1.3 (283) 1.2 Dep., Amort./ (32) 1.9 (103) 1.2 (40) 1.2 (57) 1.0 (29) 1.0 (22) 1.4
2.0 2.2 2.1 Sales 3.7 2.4 2.0 1.5 1.4 1.9
1.7 1.9 1.6 % Officers’, 4.0 1.8 1.7 1.5 1.2
(197) 3.1 (201) 3.5 (220) 3.4 Directors’, Owners’ (26) 6.8 (90) 3.9 (36) 3.3 (46) 2.3 (15) 2.0
5.4 5.6 5.6 Comp/Sales 9.7 5.7 4.3 5.0 3.2

5286386M 3234499M 3274629M Net Sales ($) 31281M 275677M 205299M 428265M 553714M 1780393M
2072674M 1496318M 1464549M Total Assets ($) 18939M 134776M 101186M 176737M 257734M 775177M
M = $ thousand; MM = $ million.
© 2012 by RMA. All rights reserved. No part of this table may be reproduced or utilized in any form or by any means, electronic or mechanical, including
photocopying, recording, or by any information storage and retrieval system, without permission in writing from RMA—Risk Management Association.

On the left, we have three years’ worth of summary historical information for the en-
tire group. For example, operating expenses rose from 34.7 percent of sales to 36.4 percent
over that time.
Table 3.12 contains some selected ratios, again reported by sales groups on the right
and time period on the left. To see how we might use this information, suppose our firm
has a current ratio of 2. Based on the ratios, is this value unusual?
Looking at the current ratio for the overall group for the most recent year (third column
from the left in Table 3.12), we see that three numbers are reported. The one in the middle, 2.8,
is the median, meaning that half of the 369 firms had current ratios that were lower and half had
bigger current ratios. The other two numbers are the upper and lower quartiles. So, 25 percent
of the firms had a current ratio larger than 4.5 and 25 percent had a current ratio smaller than
1.6. Our value of 2 falls comfortably within these bounds, so it doesn’t appear too unusual. This
comparison illustrates how knowledge of the range of ratios is important in addition to knowl-
edge of the average. Notice how stable the current ratio has been for the last three years.

EXAMPLE 3.5 More Ratios

Take a look at the most recent numbers reported for Sales/Receivables and EBIT/lnterest in
Table 3.12. What are the overall median values? What are these ratios?
If you look back at our discussion, you will see that these are the receivables turnover and the
times interest earned, or TIE, ratios. The median value for receivables turnover for the entire group
is 45.6 times. So, the days in receivables would be 365/45.6 = 8, which is the bold-faced number
reported. The median for the TIE is 3.0 times. The number in parentheses indicates that the calcula-
tion is meaningful for, and therefore based on, only 336 of the 369 companies. In this case, the
reason is that only 336 companies paid any significant amount of interest.
 CHAPTER 3 Working with Financial Statements 79

There are many sources of ratio information in addition to the one we examine here.
The nearby Work the Web box shows how to get this information for just about any com-
pany, along with some very useful benchmarking information. Be sure to look it over and
then benchmark your favorite company.

Problems with Financial Statement Analysis

We close out our chapter on working with financial statements by discussing some addi-
tional problems that can arise in using financial statements. In one way or another, the ba-
sic problem with financial statement analysis is that there is no underlying theory to help
us identify which items or ratios to look at and to guide us in establishing benchmarks.
As we discuss in other chapters, there are many cases in which financial theory and
economic logic provide guidance in making judgments about value and risk. Very little
such help exists with financial statements. This is why we can’t say which ratios matter the
most and what a high or low value might be.
One particularly severe problem is that many firms, such as General Electric (GE), are
conglomerates owning more or less unrelated lines of business. The consolidated financial

W RK THE WEB
A s we discussed in this chapter, ratios are an important tool for examining a company’s perfor-
mance, but gathering the necessary information can be tedious and time-consuming. Fortu-
nately, many sites on the web provide this information for free. We went to www.reuters.com,
entered the ticker symbol “GPS” (for The Gap), and then went to the financials page. Here is an
abbreviated look at the results:

In looking at the Management Effectiveness ratios (or what we call Profitability ratios), The
Gap has outperformed the company and sector for both the 1-year and 5-year periods reported.

QUESTIONS
1. Go to www.reuters.com and find the major ratio categories listed on this website. How
do the categories differ from the categories listed in the textbook?
2. Go to www.reuters.com and find all the ratios for The Gap. How is the company per-
forming in each ratio category presented on this website?
FINANCE M AT T E RS

What’s in a Ratio?
A braham Briloff, a well-known financial commentator,
famously remarked that “financial statements are like fine
perfume; to be sniffed but not swallowed.” As you have proba-
company loses, the higher the ROE becomes. Also, in this
case, both the market-to-book and PE ratios are negative.
How do you interpret a negative PE? We’re not really sure
bly figured out by now, his point is that information gleaned from either. Whenever a company has a negative book value of
financial statements—and ratios and growth rates computed equity, it means the losses for the company have been so
from that information—should be taken with a grain of salt. large that they have erased all the book equity. In this case,
For example, looking back at our chapter opener re- ROE, PE ratios, and market-to-book ratios are usually not re-
garding PE ratios, investors must really think that 3D Sys- ported because they lack meaning.
tems will have extraordinary growth. After all, they are willing Even if a company’s book equity is positive, you still
to pay about $252 for every dollar the company currently have to be careful. For example, consider B/E Aerospace,
earns, which definitely makes it look like a growth company. which had a market-to-book ratio of about 650 at the end of
Looking back, from 2009 to 2014, 3D Systems’ revenue in- the company’s 2014 fiscal year. Because this ratio measures
creased by 12 percent per year. More important, looking the value created by the company for shareholders, things
ahead, the well-known independent investment research look pretty good for the company. But a closer look shows
company Value Line projected revenue growth of 23 per- that B/E Aerospace’s book value of equity per share was
cent per year and earnings growth of 17 percent per year $24.69 in 2013, but it dropped to $.10 in 2014 even though
over the next five years for 3D Systems. the company posted a positive net income for the year. As it
Another problem that can occur with ratio analysis is happens, the drop was due to accounting charges related to
negative equity. Let’s look at clothing company American the split of the company into two companies, not economic
Apparel, for example. The company reported a loss of about gains or losses, but it nonetheless dramatically increased
$68.82 million dollars during 2014, and its book value of eq- the market-to-book ratio during this period.
uity was negative $115.52 million. If you calculate the ROE Financial ratios are important tools used in evaluating
for the company, you will find that it is about 60 percent, companies of all types, but you cannot simply take a number
which is outstanding. Unfortunately, if you examine the ROE as given. Instead, before doing any analysis, the first step is
a little closer you will find something unusual: The more the to ask whether the number actually makes sense.

statements for such firms don’t really fit any neat industry category. More generally, the kind of
peer group analysis we have been describing is going to work best when the firms are strictly in
the same line of business, the industry is competitive, and there is only one way of operating.
Another problem that is becoming increasingly common is that major competitors and
natural peer group members in an industry may be scattered around the globe. The automo-
bile industry is an obvious example. The problem here is that financial statements from
outside the United States do not necessarily conform at all to GAAP (more precisely, differ-
ent countries can have different GAAPs). The existence of different standards and proce-
dures makes it very difficult to compare financial statements across national borders.
Even companies that are clearly in the same line of business may not be comparable. For
example, electric utilities engaged primarily in power generation are all classified in the same
group (SIC 4911). This group is often thought to be relatively homogeneous. However, utilities
generally operate as regulated monopolies, so they don’t compete with each other. Many have
stockholders, and many are organized as cooperatives with no stockholders. There are several
different ways of generating power, ranging from hydroelectric to nuclear, so the operating ac-
tivities can differ quite a bit. Finally, profitability is strongly affected by regulatory environ-
ment, so utilities in different locations can be very similar but show very different profits.
Several other general problems frequently crop up. First, different firms use different
accounting procedures—for inventory, for example. This makes it difficult to compare state-
ments. Second, different firms end their fiscal years at different times. For firms in seasonal
businesses (such as a retailer with a large Christmas season), this can lead to difficulties in
80
 CHAPTER 3 Working with Financial Statements 81

comparing balance sheets because of fluctuations in accounts during the year. Finally, for
any particular firm, unusual or transient events, such as a one-time profit from an asset sale,
may affect financial performance. In comparing firms, such events can give misleading
signals. Our nearby Finance Matters box discusses some additional issues.
CONCE P T Q U ES T I O N S
3.5a What are some uses for financial statement analysis?
3.5b What are SIC codes and how might they be useful?
3.5c Why do we say that financial statement analysis is management by exception?
3.5d What are some of the problems that can come up with financial statement analysis?

SUMMARY AND CONCLUSIONS

This chapter has discussed aspects of financial statement analysis, including:
1. Standardized financial statements. We explained that differences in firm size make it
difficult to compare financial statements, and we discussed how to form common-
size statements to make comparisons easier.
2. Ratio analysis. Evaluating ratios of accounting numbers is another way of comparing
financial statement information. We therefore defined and discussed a number of the
most commonly reported and used financial ratios. We also discussed the famous
DuPont identity as a way of analyzing financial performance, and we examined the
connection between profitability, financial policy, and growth.
3. Using financial statements. We described how to establish benchmarks for
comparison purposes and discussed some of the types of information that are
available. We then examined some of the potential problems that can arise.
After you have studied this chapter, we hope that you will have some perspective on
the uses and abuses of financial statements. You should also find that your vocabulary of
business and financial terms has grown substantially.

POP QUIZ!
Can you answer the following questions? If your class is using Connect, log on to
SmartBook to see if you know the answers to these and other questions, check out
the study tools, and find out what topics require additional practice!
Section 3.1 A common-size balance sheet expresses all accounts as a percentage
of what?
Section 3.2 What are the categories of traditional financial ratios?
Section 3.3 According to the DuPont identity, what factors affect ROE?
Section 3.4 Bubbles, Inc., has a return on equity of 12 percent and its retention ratio
is 60 percent. What is its sustainable growth rate?
Section 3.5 When should market information be used when analyzing financial
transactions?
82 PART 2 Understanding Financial Statements and Cash Flow

CHAPTER REVIEW AND SELF-TEST PROBLEMS

3.1 Common-Size Statements. Here are the most recent financial statements for
Wildhack. Prepare a common-size income statement based on this information.
How do you interpret the standardized net income? What percentage of sales goes
to cost of goods sold? (See Problem 15.)

WILDHACK CORPORATION
2016 Income Statement
($ in millions)

Sales $3,756
Cost of goods sold 2,453
Depreciation 490
Earnings before interest and taxes $ 813
Interest paid 613
Taxable income $ 200
Taxes (34%) 68
Net income $ 132
Dividends $46
Addition to retained earnings 86

WILDHACK CORPORATION
Balance Sheets as of December 31, 2015 and 2016
($ in millions)

2015 2016 2015 2016

Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash $ 120 $ 88 Accounts payable $ 124 $ 144
Accounts receivable 224 192 Notes payable 1,412 1,039
Inventory 424 368 Total $1,536 $1,183
Total $ 768 $ 648 Long-term debt $1,804 $2,077
Fixed assets Owners’ equity
Net plant and equipment $5,228 $5,354 Common stock and
paid-in surplus $ 300 $ 300
Retained earnings 2,356 2,442
Total assets $5,996 $6,002 Total $2,656 $2,742
Total liabilities and
owners’ equity $5,996 $6,002
 CHAPTER 3 Working with Financial Statements 83

3.2 Financial Ratios. Based on the balance sheets and income statement in the
previous problem, calculate the following ratios for 2016: (See Problem 35.)
Current ratio
Quick ratio
Cash ratio
Inventory turnover
Receivables turnover
Days’ sales in inventory
Days’ sales in receivables
Total debt ratio
Times interest earned ratio
Cash coverage ratio

3.3 ROE and the DuPont Identity. Calculate the 2016 ROE for the Wildhack
Corporation and then break down your answer into its component parts using the
DuPont identity. (See Problem 36.)
3.4 Sustainable Growth. Based on the following information, what growth rate can
Corwin maintain if no external financing is used? What is the sustainable growth
rate? (See Problems 20, 21.)

CORWIN COMPANY
Financial Statements

Income Statement Balance Sheet

Sales $2,750 Current assets $ 600 Long-term debt $ 200
Cost of sales 2,400 Net fixed assets 800 Equity 1,200
Tax (34%) 119 Total $1,400 Total $1,400
Net income $ 231
Dividends $ 77

■ Answers to Chapter Review and Self-Test Problems

3.1 We’ve calculated the common-size income statement below. Remember that we
simply divide each item by total sales.

WILDHACK CORPORATION
2016 Common-Size Income Statement

Sales 100.0%
Cost of goods sold 65.3
Depreciation 13.0
Earnings before interest and taxes 21.6
Interest paid 16.3
Taxable income 5.3
Taxes (34%) 1.8
Net income 3.5%
Dividends 1.2%
Addition to retained earnings 2.3
84 PART 2 Understanding Financial Statements and Cash Flow

Net income is 3.5 percent of sales. Because this is the percentage of each sales dollar
that makes its way to the bottom line, the standardized net income is the firm’s profit
margin. Cost of goods sold is 65.3 percent of sales.
3.2 We’ve calculated the ratios below based on the ending figures. If you don’t
remember a definition, refer back to Table 3.5.
Current ratio $648/$1,183 = .55 times
Quick ratio $280/$1,183 = .24 times
Cash ratio $88/$1,183 = .07 times
Inventory turnover $2,453/$368 = 6.7 times
Receivables turnover $3,756/$192 = 19.6 times
Days’ sales in inventory 365/6.7 = 54.5 days
Days’ sales in receivables 365/19.6 = 18.6 days
Total debt ratio $3,260/$6,002 = 54.3%
Times interest earned ratio $813/$613 = 1.33 times
Cash coverage ratio $1,303/$613 = 2.13 times
3.3 The return on equity is the ratio of net income to total equity. For Wildhack, this is
$132/$2,742 = 4.8%, which is not outstanding. Given the DuPont identity, ROE can
be written as:
ROE = Profit margin × Total asset turnover × Equity multiplier
= $132/$3,756 × $3,756/$6,002 × $6,002/$2,742
= 3.5% × .626 × 2.19
= 4.8%
Notice that return on assets, ROA, is 3.5% × .626 = 2.2%.
3.4 Corwin retains b = (1 − .33) = 2∕3 ≈ .67 of net income. Return on assets is
$231/$1,400 = 16.5%. The internal growth rate is:

ROA × b .165 × 2∕3

= = 12.36%
1 − ROA × b 1 − .165 × 2∕3
Return on equity for Corwin is $231/$1,200 = 19.25%, so we can calculate the
sustainable growth rate as:

ROE × b .1925 × 2∕3

= = 14.72%
1 − ROE × b 1 − .1925 × 2∕3

CRITICAL THINKING AND CONCEPTS REVIEW

LO 2 3.1 Current Ratio. What effect would the following actions have on a firm’s
current ratio? Assume that net working capital is positive.
a. Inventory is purchased.
b. A supplier is paid.
c. A short-term bank loan is repaid.
d. A long-term debt is paid off early.
e. A customer pays off a credit account.
 CHAPTER 3 Working with Financial Statements 85

f. Inventory is sold at cost.

g. Inventory is sold for a profit.
LO 2 3.2 Current Ratio and Quick Ratio. In recent years, Dixie Co. has greatly
increased its current ratio. At the same time, the quick ratio has fallen.
What has happened? Has the liquidity of the company improved?
LO 2 3.3 Current Ratio. Explain what it means for a firm to have a current ratio
equal to .50. Would the firm be better off if the current ratio were 1.50?
What if it were 15.0? Explain your answers.
LO 2 3.4 Financial Ratios. Fully explain the kind of information the following
financial ratios provide about a firm:
a. Quick ratio
b. Cash ratio
c. Capital intensity ratio
d. Total asset turnover
e. Equity multiplier
f. Times interest earned ratio
g. Profit margin
h. Return on assets
i. Return on equity
j. Price–earnings ratio
LO 1 3.5 Standardized Financial Statements. What types of information do
common-size financial statements reveal about the firm? What is the best
use for these common-size statements?
LO 2 3.6 Peer Group Analysis. Explain what peer group analysis means. As a
financial manager, how could you use the results of peer group analysis to
evaluate the performance of your firm? How is a peer group different from
an aspirant group?
LO 3 3.7 DuPont Identity. Why is the DuPont identity a valuable tool for analyzing
the performance of a firm? Discuss the types of information it reveals as
compared to ROE considered by itself.
LO 2 3.8 Industry-Specific Ratios. Specialized ratios are sometimes used in
specific industries. For example, the so-called book-to-bill ratio is closely
watched for semiconductor manufacturers. A ratio of .93 indicates that for
every $100 worth of chips shipped over some period, only $93 worth of
new orders were received. In January 2015 the North American
semiconductor equipment industry’s book-to-bill ratio was 1.03, with
orders of $1.314 billion and billings of $1.276 billion. The most recent
peak in the book-to-bill ratio was in February 2010 when it reached 1.23.
The most recent low occurred in January 2009 when it reached .47. What
is this ratio intended to measure? Why do you think it is so closely
followed?
LO 2 3.9 Industry-Specific Ratios. So-called same-store sales are a very
important measure for companies as diverse as McDonald’s and Sears.
As the name suggests, examining same-store sales means comparing
revenues from the same stores or restaurants at two different points in
time. Why might companies focus on same-store sales rather than total
sales?
86 PART 2 Understanding Financial Statements and Cash Flow

LO 2 3.10 Industry-Specific Ratios. There are many ways of using standardized

financial information beyond those discussed in this chapter. The usual
goal is to put firms on an equal footing for comparison purposes. For
example, for auto manufacturers, it is common to express sales, costs, and
profits on a per-car basis. For each of the following industries, give an
example of an actual company and discuss one or more potentially useful
means of standardizing financial information:
a. Public utilities
b. Large retailers
c. Airlines
d. Online services
e. Hospitals
f. College textbook publishers
LO 2 3.11 Financial Statement Analysis. You are examining the common-size
income statements for a company for the past five years and have noticed
that the cost of goods as a percentage of sales has been increasing steadily.
At the same time, EBIT as a percentage of sales has been decreasing.
What might account for the trends in these ratios?
LO 2 3.12 Financial Statement Analysis. In the previous question, what actions
might managers take to improve these ratios?

QUESTIONS AND PROBLEMS

Select problems are available in McGraw-Hill Connect. Please see the pack-
aging options section of the preface for more information.

BASIC (Questions 1–26)

LO 2 1. Calculating Liquidity Ratios. SDJ, Inc., has net working capital of $1,965,
current liabilities of $5,460, and inventory of $2,170. What is the current
ratio? What is the quick ratio?
LO 2 2. Calculating Profitability Ratios. Aguilera, Inc., has sales of $13.5
million, total assets of $8.7 million, and total debt of $4.1 million. If
the profit margin is 7 percent, what is net income? What is ROA? What
is ROE?
LO 2 3. Calculating the Average Collection Period. Ordonez Lumber Yard has a
current accounts receivable balance of $583,174. Credit sales for the year
just ended were $6,787,626. What is the receivables turnover? The days’
sales in receivables? How long did it take on average for credit customers to
pay off their accounts during the past year?
LO 2 4. Calculating Inventory Turnover. Bobaflex Corporation has ending
inventory of $527,156 and cost of goods sold for the year just ended was
$8,543,132. What is the inventory turnover? The days’ sales in inventory?
How long on average did a unit of inventory sit on the shelf before it was
sold?
 CHAPTER 3 Working with Financial Statements 87

LO 2 5. Calculating Leverage Ratios. Fincher, Inc., has a total debt ratio of .19.
What is its debt–equity ratio? What is its equity multiplier?
LO 2 6. Calculating Market Value Ratios. Rossdale, Inc., had additions to retained
earnings for the year just ended of $534,000. The firm paid out $185,000
in cash dividends, and it has ending total equity of $7.45 million. If the
company currently has 365,000 shares of common stock outstanding, what
are earnings per share? Dividends per share? What is book value per share?
If the stock currently sells for $49 per share, what is the market-to-book
ratio? The price–earnings ratio? If total sales were $15.4 million, what is the
price–sales ratio?
LO 3 7. DuPont Identity. If jPhone, Inc., has an equity multiplier of 1.83, total
asset turnover of 1.65, and a profit margin of 5.2 percent, what is its
ROE?
LO 3 8. DuPont Identity. Jiminy Cricket Removal has a profit margin of 7.6
percent, total asset turnover of 1.73, and ROE of 17.2 percent. What is this
firm’s debt–equity ratio?
LO 2 9. Calculating Average Payables Period. For the past year, Coach, Inc., had
a cost of goods sold of $87,386. At the end of the year, the accounts payable
balance was $19,472. How long on average did it take the company to pay
off its suppliers during the year? What might a large value for this ratio
imply?
LO 2 10. Equity Multiplier and Return on Equity. Shelton Company has a
debt–equity ratio of .75. Return on assets is 6.9 percent, and total
equity is $815,000. What is the equity multiplier? Return on equity?
Net income?
LO 3 11. Internal Growth. If Williams, Inc., has an ROA of 7.2 percent and a payout
ratio of 25 percent, what is its internal growth rate?
LO 3 12. Sustainable Growth. If the Crash Davis Driving School has an ROE of
16.8 percent and a payout ratio of 20 percent, what is its sustainable growth
rate?
LO 3 13. Sustainable Growth. Based on the following information, calculate the
sustainable growth rate for Southern Lights Co.:
Profit margin = 8.1%
Capital intensity ratio = .45
Debt–equity ratio = .55
Net income = $120,000
Dividends = $65,000
LO 3 14. Sustainable Growth. Assuming the following ratios are constant, what is
the sustainable growth rate?
Total asset turnover = 2.80
Profit margin = 5.7%
Equity multiplier = 1.47
Payout ratio = 55%
Bethesda Mining Company reports the following balance sheet information
for 2015 and 2016. Use this information to work Problems 15 through 17.
88 PART 2 Understanding Financial Statements and Cash Flow

BETHESDA MINING COMPANY

Balance Sheets as of December 31, 2015 and 2016

2015 2016 2015 2016

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 19,256 $ 21,946 Accounts payable $171,531 $153,984
Accounts receivable 46,396 54,486 Notes payable 79,218 107,606
Inventory 109,626 129,253 Total $250,749 $261,590
Total $175,278 $205,685 Long-term debt $255,000 $278,500
Owners’ equity
Common stock and paid-in surplus $160,000 $170,000
Fixed assets Accumulated retained earnings 214,915 280,800
Net plant and equipment $705,386 $785,205 Total $374,915 $450,800
Total assets $880,664 $990,890 Total liabilities and owners’ equity $880,664 $990,890

LO 1 15. Preparing Standardized Financial Statements. Prepare the 2015 and 2016
common-size balance sheets for Bethesda Mining.
LO 2 16. Calculating Financial Ratios. Based on the balance sheets given for
Bethesda Mining, calculate the following financial ratios for each year:
a. Current ratio
b. Quick ratio
c. Cash ratio
d. Debt–equity ratio and equity multiplier
e. Total debt ratio
LO 3 17. DuPont Identity. Suppose that the Bethesda Mining Company had sales of
$2,945,376 and net income of $89,351 for the year ending December 31,
2016. Calculate the DuPont identity.
LO 3 18. DuPont Identity. The Cavo Company has an ROA of 8.1 percent, a profit
margin of 5.8 percent, and an ROE of 16 percent. What is the company’s
total asset turnover? What is the equity multiplier?
LO 2 19. Return on Assets. Beckinsale, Inc., has a profit margin of 5.8 percent on
sales of $14,500,000. If the firm has debt of $7,300,000 and total assets of
$11,200,000, what is the firm’s ROA?
LO 3 20. Calculating Internal Growth. The most recent financial statements for
Shinoda Manufacturing Co. are shown here:

Income Statement Balance Sheet

Sales $87,600 Current assets $ 29,000 Debt $ 38,400

Costs 64,350 Fixed assets 91,400 Equity 82,000
Taxable income $23,250 Total $120,400 Total $120,400
Tax (35%) 8,138
Net Income $15,112
 CHAPTER 3 Working with Financial Statements 89

Assets and costs are proportional to sales. Debt and equity are not. The com-
pany maintains a constant 40 percent dividend payout ratio. No external fi-
nancing is possible. What is the internal growth rate?
LO 3 21. Calculating Sustainable Growth. For Shinoda Manufacturing in Problem
20, what is the sustainable growth rate?
LO 2 22. Total Asset Turnover. Kaleb’s Karate Supply had a profit margin of
7.9 percent, sales of $13.8 million, and total assets of $7.1 million. What
was total asset turnover? If management set a goal of increasing total asset
turnover to 2.75 times, what would the new sales figure need to be,
assuming no increase in total assets?
LO 2 23. Return on Equity. Carroll, Inc., has a total debt ratio of .75, total debt of
$353,000, and net income of $18,750. What is the company’s return on
equity?
LO 2 24. Market Value Ratios. Ames, Inc., has a current stock price of $58. For
the past year, the company had net income of $8,400,000, total equity of
$25,300,000, sales of $52,800,000, and 4.6 million shares of stock
outstanding. What are earnings per share (EPS)? Price–earnings ratio?
Price–sales ratio? Book value per share? Market-to-book ratio?
LO 3 25. Profit Margin. Dimeback Co. has total assets of $7,450,000 and a total
asset turnover of 1.8 times. If the return on assets is 8.25 percent, what is its
profit margin?
LO 2 26. Enterprise Value–EBITDA Multiple. The market value of the equity of
Ginger, Inc., is $635,000. The balance sheet shows $39,000 in cash and
$215,000 in debt, while the income statement has EBIT of $96,400 and a
total of $168,000 in depreciation and amortization. What is the enterprise
value–EBITDA multiple for this company?
INTERMEDIATE (Questions 27–46)

LO 3 27. Using the DuPont Identity. Y3K, Inc., has sales of $10,570, total assets of
$4,670, and a debt–equity ratio of .25. If its return on equity is 15 percent,
what is its net income?
LO 2 28. Ratios and Fixed Assets. The Smathers Company has a long-term debt
ratio (i.e., the ratio of long-term debt to long-term debt plus equity) of .45
and a current ratio of 1.30. Current liabilities are $2,435, sales are $11,610,
profit margin is 9 percent, and ROE is 12.8 percent. What is the amount of
the firm’s net fixed assets?
LO 2 29. Profit Margin. In response to complaints about high prices, a grocery chain
runs the following advertising campaign: “If you pay your child $2 to go
buy $50 worth of groceries, then your child makes twice as much on the
trip as we do.” You’ve collected the following information from the grocery
chain’s financial statements:

(in millions)

Sales $790.00
Net income 15.80
Total assets 365.00
Total debt 229.80
90 PART 2 Understanding Financial Statements and Cash Flow

Evaluate the grocery chain’s claim. What is the basis for the statement? Is
this claim misleading? Why or why not?
LO 3 30. Using the DuPont Identity. The Dahlia Company has net income of
$162,840. There are currently 29.38 days’ sales in receivables. Total assets
are $794,350, total receivables are $145,350, and the debt–equity ratio is
.25. What is the company’s profit margin? Its total asset turnover? Its ROE?
LO 2 31. Calculating the Cash Coverage Ratio. Delectable Parsnip, Inc.’s, net
income for the most recent year was $8,417. The tax rate was 34 percent.
The firm paid $4,632 in total interest expense and deducted $5,105 in
depreciation expense. What was the company’s cash coverage ratio for
the year?
LO 2 32. Calculating the Times Interest Earned Ratio. For the most recent year,
Seether, Inc., had sales of $534,000, cost of goods sold of $241,680,
depreciation expense of $60,400, and additions to retained earnings of
$72,800. The firm currently has 20,000 shares of common stock outstanding,
and the previous year’s dividends per share were $1.35. Assuming a 34
percent income tax rate, what was the times interest earned ratio?
LO 2 33. Return on Assets. A fire has destroyed a large percentage of the financial
records of the Excandesco Company. You have the task of piecing together
information in order to release a financial report. You have found the return
on equity to be 12.9 percent. Sales were $1,840,000, the total debt ratio was
.37, and total debt was $673,000. What is the return on assets (ROA)?
LO 2 34. Ratios and Foreign Companies. Prince Albert Canning PLC had a net loss
of £27,860 on sales of £512,621. What was the company’s profit margin?
Does the fact that these figures are quoted in a foreign currency make any
difference? Why? In dollars, sales were $765,828. What was the net loss in
dollars?
Some recent financial statements for Smolira Golf, Inc., follow. Use this infor-
mation to work Problems 35 through 38.

SMOLIRA GOLF, INC.

Balance Sheets as of December 31, 2015 and 2016

2015 2016 2015 2016

Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash $ 4,607 $ 4,910 Accounts payable $ 3,413 $ 3,846
Accounts receivable 6,702 8,149 Notes payable 2,768 3,416
Inventory 17,357 19,350 Other 138 165
Total $28,666 $ 32,409 Total $ 6,319 $ 7,427
Long-term debt $22,500 $ 19,000
Owners’ equity
Common stock and paid-in surplus $38,000 $ 38,000
Fixed assets Accumulated retained earnings 20,535 44,792
Net plant and equipment 58,688 76,810 Total $58,535 $ 82,792
Total assets $87,354 $109,219 Total liabilities and owners’ equity $87,354 $109,219
 CHAPTER 3 Working with Financial Statements 91

SMOLIRA GOLF, INC.

2016 Income Statement

Sales $205,227
Cost of goods sold 138,383
Depreciation 5,910
EBIT $ 60,934
Interest paid 1,617
Taxable income $ 59,317
Taxes 20,760
Net income $ 38,557
Dividends $14,300
Additions to retained earnings 24,257

LO 2 35. Calculating Financial Ratios. Find the following financial ratios for Smolira
Golf (use year-end figures rather than average values where appropriate):
Short-term solvency ratios
a. Current ratio ________________
b. Quick ratio ________________
c. Cash ratio ________________
Asset utilization ratios
d. Total asset turnover ________________
e. Inventory turnover ________________
f. Receivables turnover ________________
Long-term solvency ratios
g. Total debt ratio ________________
h. Debt–equity ratio ________________
i. Equity multiplier ________________
j. Times interest earned ratio ________________
k. Cash coverage ratio ________________
Profitability ratios
l. Profit margin ________________
m. Return on assets ________________
n. Return on equity ________________

LO 3 36. DuPont Identity. Construct the DuPont identity for Smolira Golf.
LO 2 37. Market Value Ratios. Smolira Golf has 10,000 shares of common stock
outstanding, and the market price for a share of stock at the end of 2016 was
$73. What is the price–earnings ratio? What is the price–sales ratio? What are
the dividends per share? What is the market-to-book ratio at the end of 2016?
92 PART 2 Understanding Financial Statements and Cash Flow

LO 2 38. Interpreting Financial Ratios. After calculating the ratios for Smolira Golf,
you have uncovered the following industry ratios for 2016:

Lower Quartile Median Upper Quartile

Current ratio 1.3 2.6 5.3

Total asset turnover 2.1 2.7 4.1
Debt–equity ratio .25 .50 .60
Profit margin 8.4% 11.9% 16.3%

How is Smolira Golf performing based on these ratios?

LO 3 39. Growth and Profit Margin. Fulkerson Manufacturing wishes to maintain a
sustainable growth rate of 8 percent a year, a debt–equity ratio of .85, and
a dividend payout ratio of 30 percent. The ratio of total assets to sales is
constant at 1.35. What profit margin must the firm achieve?
LO 2 40. Market Value Ratios. Abercrombie & Fitch and American Eagle Outfitters
(AEO), reported the following numbers (in millions) for fiscal year 2014.
Calculate the earnings per share, market-to-book ratio, and price–earnings
ratio for each company.

Abercrombie AEO

Net income $ 51.821 $ 80.322

Shares outstanding 68.98 195.43
Stock price $ 24.81 $ 13.84
Total equity $1,389.701 $1,139.746

LO 3 41. Growth and Assets. A firm wishes to maintain an internal growth rate of
6.8 percent and a dividend payout ratio of 25 percent. The current profit
margin is 7.3 percent and the firm uses no external financing sources. What
must total asset turnover be?

LO 3 42. Sustainable Growth. Based on the following information, calculate the

sustainable growth rate for Sully, Inc.:
Profit margin = 5.2%
Total asset turnover = 1.90
Total debt ratio = .30
Payout ratio = 15%

What is the ROA here?

LO 3 43. Sustainable Growth and Outside Financing. You’ve collected the

following information about Erna, Inc.:
Sales = $275,000
Net income = $19,000
Dividends = $8,100
Total debt = $67,000
Total equity = $91,000
 CHAPTER 3 Working with Financial Statements 93

What is the sustainable growth rate for the company? If it does grow at this
rate, how much new borrowing will take place in the coming year, assuming
a constant debt–equity ratio? What growth rate could be supported with no
outside financing at all?

LO 4 44. Constraints on Growth. High Flyer, Inc., wishes to maintain a growth rate
of 13 percent per year and a debt–equity ratio of .35. The profit margin is
6 percent, and total asset turnover is constant at 1.10. Is this growth rate
possible? To answer, determine what the dividend payout ratio must be.
How do you interpret the result?
LO 3 45. Internal and Sustainable Growth Rates. Best Buy reported the following
numbers (in millions) for the years ending February 1, 2014, and January 31,
2015. What are the internal and sustainable growth rates? What are the
internal and sustainable growth rates using ROE × b and (ROA × b) and
the end of period equity (assets)? What are the growth rates if you use the
beginning of period equity in this equation? Why aren’t the growth rates
the same? What is your best estimate of the internal and sustainable
growth rates?

2014 2015

Net income $ 1,233

Dividends 251
Total assets $14,013 15,256
Total equity 3,986 4,995

LO 3 46. Expanded DuPont Identity. Hershey Co. reported the following income
statement and balance sheet (in millions) for 2014. Construct the expanded
DuPont identity similar to Figure 3.1. What is the company’s return on
equity?

Income Statement Balance Sheet

Sales $7,421.768 Assets Liabilities & Equity

CoGS 4,085.602 Current assets Current liabilities $1,935.647
Other costs 1,770.279 Cash $ 471.985
Depreciation 176.312 Accounts receivable 697.455 Long-term debt $2,238.807
EBIT $1,389.575 Inventory 1,077.607
Interest 83.532 Total $2,247.047 Shareholders’ equity $1,455.062
EBT $1,306.043 Fixed assets $3,382.469
Taxes 459.131 Total assets $5,629.516 Total liabilities and $5,629.516
Net income $ 846.912 shareholders’ equity