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    92

    Analysis

    of FinancialStatementsMoney is better than poverty, i only or

    fnancial reasons.

    Woody Allen

    Financial Statements Tell the Story

    On its website, The Scotts Company, headquartered in Ohio or more than137 years, says it is the worlds leading supplier and marketer o consumerproducts or do-it-yoursel lawn and garden care. Scotts brands includeMiracle-Gro, the leading plant ertilizer. In its 2005 Annual Report, thecompany adds that it is dedicated to delivering strong, consistent nancial

    results and outstanding shareholder returns.1

    A ew questions:

    On what basis does the company make the claim that it is the leading supplierand marketer o lawn- and garden-care products?

    What does the company mean when it says Miracle-Gro is the leading plantertilizer?

    What constitutes strong, consistent nancial results?

    How are shareholder returns measured and how high do they have to be to beregarded as outstanding?

    The answers to these questions and more can be ound by examining thecompanys nancial statements. For example, by comparing Scotts incomestatement and balance sheet with those o other companies, you could ndout whether the claim that Scotts is the leading company is based on itssales, its prots, or its assets. A more in-depth look at the statements wouldreveal whether Scotts really does deliver strong, consistent nancial results andoutstanding shareholder returns according to your own investment criteria.

    1Source: The Scotts company website (www.scotts.com) and 2005 Annual Report, page 21.

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    93

    Jostein Hauge (http://www.fotolia.com/p/

    Learning Objectives

    Ater reading this chapteyou should be able to:

    1. Explain how nancial raanalysis helps nancialmanagers assess the hea

    o a company.2. Compute protability,

    liquidity, debt, assetutilization, and marketvalue ratios.

    3. Compare nancialinormation over time anamong companies.

    4. Locate ratio value data ospecic companies andindustries.

    Financial statements are like puzzles. When you rst look at them, manyquestions arise. What does the picture look like? How do the pieces ttogether? What is a company doing? How are they doing it? As the puzzleis assembled, however, the acts begin to surace. This is what the companydid. This is how they did it. This is where the money came rom. This is whereit went. When the puzzle is complete, the companys nancial picture liesbeore you, and with that picture you can make sound judgments aboutthe companys protability, liquidity, debt management, and market value.

    Chapter Overview

    In Chapter 4 we reviewed the major nancial statements, the primary sources

    o nancial inormation about a business. In this chapter we will learn how

    to interpret these nancial statements in greater detail. All business owners,

    investors, and creditors use nancial statements and ratio analysis to investigate

    the nancial health o a rm. We will see how nancial managers calculate ratios

    that measure protability, liquidity, debt, asset activity, and market perormance

    o a rm. We will then explore how nancial experts use ratios to compare a rms

    perormance to managers goals, the rms past and present perormance, and therms perormance to similar rms in the industry. We will also discuss sources

    o nancial inormation.

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    94 Part II Essential Concepts in Finance

    Assessing Financial Health

    Medical doctors assess the health o people. Financial managers assess the health o

    businesses. When you visit a doctor or an examination, the doctor may check your

    blood pressure, heart rate, cholesterol, and blood sugar levels. The results o each test

    should all within a range o numbers considered normal or your age, weight, gender,

    and height. I they dont, the doctor will probably run additional tests to see what, i

    anything, is wrong.

    Like doctors, nancial managers check the health o businesses by running basic

    testssuch as a nancial ratio analysisto see whether a rms perormance is within

    the normal range or a company o that type. I it is not, the nancial manager runs more

    tests to see what, i anything, is wrong.

    Misleading Numbers

    Both medical doctors and nancial managers must interpret the inormation they have

    and decide what additional inormation they need to complete an analysis. For instance,

    suppose a doctor examines a six-oot, 230-pound, 22-year-old male named Dirk. The

    doctors chart shows that a healthy male o that age and height should normally weigh

    between 160 and 180 pounds. Because excess weight is a health risk, the numbers dont

    look positive.

    Beore the doctor prescribes a diet and exercise program or Dirk, she asks ollow-up

    questions and runs more tests. She learns that Dirk, a starting ullback or his college

    ootball team, has only 6 percent body at, can bench-press 380 pounds, runs a 40-yard

    dash in 4.5 seconds, has a blood pressure rate o 110/65, and a resting heart rate o 52 beats

    per minute. This additional inormation changes the doctors initial health assessment.

    Relying on incomplete inormation would have led to an inaccurate diagnosis.

    Like doctors, nancial managers need to analyze many actors to determine the

    health o a company. Indeed, or some rms the nancial statements do not provide

    the entire picture.

    In 1998 the attorneys general o many states sued the major tobacco companiesalleging liability or smoking-related illness and or advertising allegedly aimed at

    underage people. Congress also was seeking legislation that would extract hundreds

    o billions o dollars over several years rom these companies. Because the outcome

    o the pending lawsuits and legislation was uncertain, the (potential) liabilities did not

    appear on the balance sheet. Financial analysis based only on the nancial statements,

    then, gave a aulty impression o the companies health.

    As the tobacco company example demonstrates, accounting conventions may prevent

    actors aecting a rms nances rom appearing on nancial statements. Just as Dirks

    doctor looked beyond the obvious, nancial managers using ratio analysis must always

    seek complete inormation beore completing an analysis. In the sections that ollow,

    we discuss ratios based on nancial statements, ratios that use market inormation, andoutside inormation sources.

    Financial Ratios

    Financial managers use ratio analysis to interpret the raw numbers on nancial

    statements. A fnancial ratio is a number that expresses the value o one nancial

    variable relative to another. Put more simply, a nancial ratio is the result you get when

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    Chapter 5 Analysis o Financial Statements

    you divide one nancial number by another. Calculating an individual ratio is simple,

    but each ratio must be analyzed careully to eectively measure a rms perormance.

    Ratios are comparative measures. Because the ratios show relative value, they

    allow nancial analysts to compare inormation that could not be compared in its raw

    orm.2 Ratios may be used to compare:

    one ratio to a related ratio

    the rms perormance to managements goals

    the rms past and present perormances

    the rms perormance to similar rms

    For instance, say a company reaped huge revenues rom one investment, but the

    cost o the investment was high. A nancial manager could use a ratio to compare that

    investment to another that did not generate such high revenues but had low cost. Take

    the 1997 movie, Titanic, or example. That blockbuster movie has grossed more than

    $1.8 billion to date (the number-one grossing movie o all time). Compare Titanics total

    revenues to the $916 million in revenues that Shrek 2 has made since it was released in

    2004. Looking only at the total revenue gures, Titanic looks like a better investmentthan Shrek 2.

    However, analysts in the movie industry use a return-on-cost ratio (total revenues

    divided by total cost) to nd a movies net return per $1 invested. Using that ratio we see

    that Titanic, at a cost o $200 million, had a return-on-cost ratio o 9.0 ($1,800,000,000

    $200,000,000 = 9.0). Shrek 2, at a cost o $70 million, had a return-on-cost ratio o

    13.1 ($916,000,000 $70,000,000 = 13.1). Although Titanic made more total revenue,

    Shrek 2 made more money relative to its cost than did Titanic.3

    Financial managers, other business managers, creditors, and stockholders all use

    nancial ratio analysis. Specically, creditors may use ratios to see whether a business

    will have the cash fow to repay its debt and interest. Stockholders may use ratios to

    see what the long-term value o their stock will be. For example, in the rst quarter o2006 Exxon Mobil reported a prot o $8.4 billion. However, analysts on Wall Street

    had predicted that the companys prots would be slightly higher than that, so despite

    the reported prots, Exxon Mobils stock price ell $.20 a share.4

    The Basic Financial Ratios

    Financial ratios are generally divided into ve categories: protability, liquidity, debt,

    asset activity, and market value. The ratios in each group give us insights into dierent

    aspects o a rms nancial health.

    Proftability ratios measure how much company revenue is eaten up by expenses, howmuch a company earns relative to sales generated, and the amount earned relative to

    the value o the rms assets and equity.

    2Financial managers who analyze the nancial condition o the rms they work or act as nancial analysts. The term fnancial

    analyst, however, also includes nancial experts who analyze a variety o rms.

    3Source or movie protability gures: http://www.the-numbers.com/movies/records/budgets.html.

    4www.Bloomberg.com, April 27, 2006.

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    96 Part II Essential Concepts in Finance

    Liquidity ratios indicate how quickly and easily a company can obtain cash or

    its needs.

    Debt ratios measure how much a company owes to others.

    Asset activity ratios measure how eciently a company uses its assets.

    Market value ratios measure how the market value o a companys stock compares

    with its accounting values.

    Calculating the Ratios

    We will use the nancial statements or the Acme Corporation presented in Chapter 4 as

    the basis or our ratio analysis. Figure 5-1 shows Acme Corporations income statement

    or 2009, and Figure 5-2 shows its December 31, 2009, balance sheet.

    Now lets analyze Acme Corporations nancial health by calculating its protability,

    liquidity, debt, asset utilization, and market value ratios.

    Proftability Ratios

    Protability ratios measure how the rms returns compare with its sales, assetinvestments, and equity. Stockholders have a special interest in the protability ratios

    because prot ultimately leads to cash fow, a primary source o value or a rm.

    Managers, acting on behal o stockholders, also pay close attention to protability

    ratios to ensure that the managers preserve the rms value.

    We will discuss ve protability ratios: gross prot margin, operating prot margin,

    net prot margin, return on assets, and return on equity. Some o the protability ratios

    use gures rom two dierent nancial statements.

    Figure 5-1Acme CorporationIncome Statementor the Year EndedDecember 31, 2006

    Net Sales $ 15,000,000

    Cost o Goods Sold 5,000,000

    Gross Prot 10,000,000

    Depreciation Expense 2,000,000

    S&A Expenses 800,000

    Operating Income (EBIT) 7,200,000

    Interest Expense 1,710,000

    Income beore Taxes 5,490,000Income Taxes 2,306,000

    Net Income $ 3,184,000

    Earnings per Share (4,000,000 shares) $ 0.80

    Dividends Paid $ 400,000

    Change in Retained Earnings $ 2,784,000

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    Chapter 5 Analysis o Financial Statements

    Gross Proft Margin The gross proft margin measures how much prot remains out o

    each sales dollar ater the cost o the goods sold is subtracted. The ratio ormula ollows:

    Gross Profit MarginGross Profit

    Sales

    $10,000,000

    $15,000,000.67, or 67%

    =

    = =

    This ratio shows how well a rm generates revenue compared with its costs ogoods sold. The higher the ratio, the better the cost controls compared with the sales

    revenues.

    To nd the gross prot margin ratio or Acme, look at Figure 5-1, Acmes income

    statement. We see that Acmes gross prot or the year was $10 million and its sales

    revenue was $15 million. Dividing $10 million by $15 million yields Acme Corporations

    gross prot margin o .67 or 67 percent. That ratio shows that Acmes cost o products

    and services sold was 33 percent o sales revenue, leaving the company with 67 percent

    o sales revenue to use or other purposes.

    Figure 5-2 AcmeCorporation Statemeno Retained Earnings the Year EndedDecember 31, 2009

    Acme Corporation Balance SheetFor the Year Ended December 31, 2006

    Assets:

    Cash $ 10,000,000

    Marketable Securities 8,000,000

    Accounts Receivable 1,000,000

    Inventory 10,000,000

    Prepaid Expenses 1,000,000

    Total Current Assets 30,000,000

    Fixed Assets, Gross 28,000,000

    Less Accumulated Depreciation (8,000,000 )

    Fixed Assets, Net 20,000,000

    Total Assets $ 50,000,00

    Liabilities and Equity:

    Accounts Payable $ 4,000,000

    Notes Payable 3,000,000

    Accrued Expenses 2,000,000

    Total Current Liabilities 9,000,000

    Long-Term Debt 15,000,000

    Total Liabilities 24,000,000

    Common Stock ($1 par) 4,000,000

    Capital in Excess o Par 12,000,000

    Retained Earnings 10,000,000

    Total Common Equity 26,000,000

    Total Liabilities and Equity $ 50,000,000

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    98 Part II Essential Concepts in Finance

    Operating Proft Margin The operating proft margin measures how much prot

    remains out o each sales dollar ater all the operating expenses are subtracted. This

    ratio is calculated by dividing earnings beore interest and taxes (EBIT or operating

    income) by sales revenue.

    Operating Profit MarginEBIT

    Sales

    $7,200,000

    $15,000,000.48, or 48%

    =

    = =

    Acmes EBIT, as shown on its income statement (see Figure 5-1), is $7,200,000.

    Dividing $7.2 million by its sales revenue o $15 million gives an operating prot

    margin o 48 percent (7,200,000 15,000,000 = .48 or 48%). Acmes operating prot

    margin indicates that 48 percent o its sales revenues remain ater subtracting all

    operating expenses.

    Net Proft Margin The net proft margin ratio measures how much prot out o each

    sales dollar is let ater all expenses are subtractedthat is, ater all operating expenses,interest, and income tax expense are subtracted. It is computed by dividing net income

    by sales revenue. Acmes net income or the year 2009 was $3.184 million. Dividing

    $3.184 million by $15 million in sales yields a 21.2 percent net prot margin. Heres

    the computation:

    NetProfit MarginNet Income

    Sales

    $3,184,000

    $15,000,000.212, or 21.2%

    =

    = =

    Net income and the net prot margin ratio are oten reerred to as bottom-linemeasures. The net prot margin includes adjustments or non-operating expenses, such

    as interest and taxes, and operating expenses. We see that in 2009 Acme Corporation

    had just over 21 percent o each sales dollar remaining ater all expenses were paid.

    Return on Assets The return on assets (ROA) ratio indicates how much income each

    dollar o assets produces on average. It shows whether the business is employing its assets

    eectively. The ROA ratio is calculated by dividing net earnings available to common

    stockholders by the total assets o the rm. For Acme Corporation, we calculate this ratio

    by dividing $3.184 million in net income (see Figure 5-1, Acme income statement) by

    $50 million o total assets (see Figure 5-2, Acme balance sheet), or a return on assets

    (ROA) o 6.4 percent. Heres the calculation:

    Return on AssetsNet Income

    Total Assets

    $3,184,000

    $50,000,000.064, or 6.4%

    =

    = =

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    Chapter 5 Analysis o Financial Statements

    In 2009, each dollar o Acme Corporations assets produced, on average, income o

    just over $.06. Although this return on assets gure may seem low, it is not unusual or

    certain types o companies, such as commercial banks, to have low ROA ratios. This is

    because such rms are asset intensive and thereore the denominator o the ROA ratio

    is large relative to the numerator.

    Return on Equity The return on equity (ROE) ratio measures the average returnon the rms capital contributions rom its owners (or a corporation, that means the

    contributions o common stockholders). It indicates how many dollars o income were

    produced or each dollar invested by the common stockholders.

    ROE is calculated by dividing net income by common stockholders equity. To

    calculate ROE or Acme Corporation, divide $3.184 million in net income by $26 million

    in total common stockholders equity (see Figure 5-2, Acme balance statement). Acmes

    ROE is 12.2 percent, shown as ollows:

    Return on EquityNet Income

    Common Stockholders Equity

    $3,184,000$26,000,000

    .122, or 12.2%

    =

    = =

    The ROE gure shows that in 2009 Acme Corporation returned, on average,

    12.2 percent or every dollar that common stockholders invested in the rm.

    Mixing Numbers rom Income Statements and Balance Sheets When nancial

    managers calculate the gross prot margin, operating prot margin, and net prot

    margin ratios, they use only income statement variables. In contrast, analysts use both

    income statement and balance sheet variables to nd the return on assets and return

    on equity ratios. A mixed ratio is a ratio that uses both income statement and balance

    sheet variables as inputs.Because income statement variables show values over a period o time and balance

    sheet variables show values or one moment in time, using mixed ratios poses the question

    o how to deal with the dierent time dimensions. For example, should the analyst select

    balance sheet variable values rom the beginning, the end, or the midpoint o the year?

    I there is a large change in the balance sheet account during the year, the choice could

    make a big dierence. Consider the ollowing situation:

    Total Assets Jan 1, 2009 $ 1,000,000

    Total Assets Dec 31, 2009 $ 2,000,000

    Net Income in 2009 $ 100,000

    Return on assets based on January 1 balance sheet:

    $100,000/$1,000,000 = .10, or 10%

    Return on assets based on December 31 balance sheet:

    $100,000/$2,000,000 = .05, or 5%

    Take Note

    Do not conuse the ROratio with the returnearned by the individcommon stockholderson their common stocinvestment. The changin the market price othe stock and dividenreceived determinethe total return on anindividuals common sinvestment.

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    100 Part II Essential Concepts in Finance

    Which gure is correct? There is no black-and-white answer to this problem. Some

    analysts add the beginning-o-the-year balance sheet gure to the end-o-the-year gure

    and divide by two to get an average gure.

    Logic and common sense suggest that analysts should pick gures that best match the

    returns to the assets or to the equity. Say that Acme purchased a large amount o assets

    early in the year. The middle- or end-o-year balance sheet gures would probably match

    the returns to the assets more eectively than beginning-o-the-year gures because

    assets can only aect prot i they have been used. For simplicity, we used end-o-yearbalance sheet gures to calculate Acmes mixed protability ratios.

    Liquidity RatiosLiquidity ratios measure the ability o a rm to meet its short-term obligations. These

    ratios are important because ailure to pay such obligations can lead to bankruptcy.

    Bankers and other lenders use liquidity ratios to see whether to extend short-term credit

    to a rm. Generally, the higher the liquidity ratio, the more able a rm is to pay its

    short-term obligations. Stockholders, however, use liquidity ratios to see how the rm

    has invested in assets. Too much investment in currentas compared with long-term

    assets indicates ineciency. The interpretation o liquidity ratio values depends on who

    is doing the analysis. A banker would likely never see a liquidity ratio value she wouldview as too high. Very high values might make a stockholder, on the other hand, wonder

    why more resources were not devoted to higher returning xed assets instead o more

    liquid but lower returning current assets.

    The two main liquidity ratios are the current ratio and the quick ratio.

    The Current Ratio The current ratio compares all the current assets o the rm (cash

    and other assets that can be quickly and easily converted to cash) with all the companys

    current liabilities (liabilities that must be paid with cash soon). At the end o 2009,

    Acme Corporations current assets were $30 million and its current liabilities were $9

    million. Dividing Acmes current assets by its current liabilities, as ollows, we see that:

    Current RatioCurrent Assets

    Current Liabilities

    $30,000,000

    $9,000,0003.33

    =

    = =

    Acmes current ratio value, then, is 3.33. The ratio result shows that Acme has $3.33

    o current assets or every dollar o current liabilities, indicating that Acme could pay

    all its short-term debts by liquidating about a third o its current assets.

    The Quick Ratio The quick ratio is similar to the current ratio but is a more rigorousmeasure o liquidity because it excludes inventory rom current assets. To calculate the

    quick ratio, then, divide current assets less inventory by current liabilities.

    Quick RatioCurrent Assets Less Inventory

    Current Liabilities

    ($30,000,000 $10,000,000)

    $9,000,0002.22

    =

    =

    =

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    Chapter 5 Analysis o Financial Statements

    This more conservative measure o a rms liquidity may be useul or some

    businesses. To illustrate, suppose a computer retail store had a large inventory o personal

    computers with out-o-date Intel Pentium III microprocessors. The computer store

    would have a tough time selling its inventory or much money.

    At the end o 2009, the balance sheet gures show that Acme Corporations current

    assets less inventory are worth $20 million ($30,000,000 $10,000,000). Its current

    liabilities are $9 million. Dividing $20 million by $9 million, we see that its quick ratio

    is 2.22. A quick ratio o 2.22 means that Acme could pay o 222 percent o its currentliabilities by liquidating its current assets, excluding inventory.

    I Acme Corporations inventory is hard to liquidate, the quick ratio is more

    important. I the company being analyzed had very liquid inventory, such as a government

    securities dealer, the quick ratio would not be a useul analysis tool compared with the

    current ratio.

    Debt RatiosFinancial analysts use debt ratios to assess the relative size o a rms debt load and

    the rms ability to pay o the debt. The three primary debt ratios are the debt to total

    assets, debt to equity, and times interest earned ratios.

    Current and potential lenders o long-term unds, such as banks and bondholders, areinterested in debt ratios. When a businesss debt ratios increase signicantly, bondholder

    and lender risk increases because more creditors compete or that rms resources i the

    company runs into nancial trouble. Stockholders are also concerned with the amount

    o debt a business has because bondholders are paid beore stockholders.

    The optimal debt ratio depends on many actors, including the type o business and

    the amount o risk lenders and stockholders will tolerate. Generally, a protable rm

    in a stable business can handle more debtand a higher debt ratiothan a rm in a

    volatile business that sometimes records losses on its income statement.

    Debt to Total Assets The debt to total assets ratio measures the percentage o the

    rms assets that is nanced with debt. Acme Corporations total debt at the end o2009 was $24 million. Its total assets were $50 million. The calculations or the debt

    to total assets ratio ollow:

    Debt to Total AssetsTotal Debt

    Total Assets

    $24,000,000

    $50,000,000.48, or 48%

    =

    = =

    Acmes debt to total assets ratio value is 48 percent, indicating that the other 52

    percent o nancing came rom equity investors (the common stockholders).

    Times Interest Earned The times interest earned ratio is oten used to assess a

    companys ability to service the interest on its debt with operating income rom the

    current period. The times interest earned ratio is equal to earnings beore interest and

    taxes (EBIT) divided by interest expense. Acme Corporation has EBIT o $7.2 million

    and interest expense o $1.71 million or 2009. Acmes times interest earned ratio is

    as ollows:

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    102 Part II Essential Concepts in Finance

    Times Interest EarnedEBIT

    Interest Expense

    $7,200,000

    $1,710,0004.2

    =

    = =

    Acmes times interest earned ratio value o 4.2 means that the company earned $4.20

    o operating income (EBIT) or each $1 o interest expense incurred during that year.A high times interest earned ratio suggests that the company will have ample

    operating income to cover its interest expense. A low ratio signals that the company may

    have insucient operating income to pay interest as it becomes due. I so, the business

    might need to liquidate assets, or raise new debt or equity unds to pay the interest due.

    Recall, however, that operating income is not the same as cash fow. Operating income

    gures do not show the amount o cash available to pay interest. Because interest

    payments are made with cash, the times interest earned ratio is only a rough measure

    o a rms ability to pay interest with current unds.

    Asset Activity RatiosFinancial analysts use asset activity ratios to measure how eciently a rm uses its

    assets. They analyze specic assets and classes o assets. The three asset activity ratios

    well examine here are the average collection period (or accounts receivable), the

    inventory turnover, and the total asset turnover ratios.

    Average Collection Period The average collection periodratio measures how many

    days, on average, the companys credit customers take to pay their accounts. Managers,

    especially credit managers, use this ratio to decide to whom the rm should extend

    credit. Slow payers are not welcome customers.

    To calculate the average collection period, divide accounts receivable by the

    companys average credit sales per day. (This in turn, is the companys annual credit

    sales divided by the number o days in a year, 365.)

    Average Collection PeriodAccounts Receivable

    Average Daily Credit Sales

    $1,000,000

    ($15,000,000/365)

    $1,000,000

    $41,09624.3 days

    =

    =

    = =

    Acme Corporation had $1 million in accounts receivable and average daily creditsales o $41,096 (i.e., $15 million total credit sales divided by 365 days in one year).

    Dividing $1 million by $41,096 gives a value o 24.3. The ratio shows that in 2009 Acme

    Corporations credit customers took an average o 24.3 days to pay their account balances.

    Notice that, in calculating the ratio, we used Acme Corporations total sales gure

    or 2009 in the denominator, assuming that all o Acmes sales or the year were made

    on credit. We made no attempt to break down Acmes sales into cash sales and credit

    sales. Financial analysts usually calculate this ratio using the total sales gure when

    they do not have the credit-sales-only gure.

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    5Many nancial analysts dene the inventory turnover ratio using cost o goods sold instead o sales in the numerator. They use

    cost o goods sold because sales is dened in terms o sales price and inventory is dened in terms o cost. We will use sales in

    the numerator o the inventory turnover ratio to be consistent with the other turnover ratios.

    Chapter 5 Analysis o Financial Statements

    Inventory Turnover The inventory turnover ratio tells us how eciently the rm

    converts inventory to sales. I the company has inventory that sells well, the ratio value

    will be high. I the inventory does not sell well due to lack o demand or i there is

    excess inventory, the ratio value will be low.

    The inventory turnover ormula ollows:

    Inventory TurnoverSales

    Inventory

    $15,000,000

    $10,000,0001.5

    =

    = =

    Acme Corporation had sales o $15 million and inventory o $10 million in 2009.

    Dividing $15 million by $10 million, we see that the inventory turnover value is 1.5.

    This number means that in 2009 Acme turned its inventory into sales 1.5 times during

    the year.5

    Total Asset Turnover The total asset turnover ratio measures how eciently a

    rm utilizes its assets. Stockholders, bondholders, and managers know that the moreeciently the rm operates, the better the returns.

    I a company has many assets that do not help generate sales (such as ancy oces

    and corporate jets or senior management), then the total asset turnover ratio will be

    relatively low. A company with a high asset turnover ratio suggests that its assets help

    promote sales revenue.

    To calculate the asset turnover ratio or Acme, divide sales by total assets as ollows:

    Total Asset TurnoverSales

    Total Assets

    $15,000,000

    $50,000,000

    .30, or 30%

    =

    = =

    The 2009 total asset turnover ratio or Acme Corporation is its sales o $15 million

    divided by its total assets o $50 million. The result is .30, indicating that Acmes sales

    were 30 percent o its assets. Put another way, the dollar amount o sales was 30 percent

    o the dollar amount o its assets.

    Market Value Ratios

    The ratios examined so ar rely on nancial statement gures. But market value ratios

    mainly rely on nancial marketplace data, such as the market price o a companys

    common stock. Market value ratios measure the markets perception o the uture earning

    power o a company, as refected in the stock share price. The two market value ratioswe discuss are the price to earnings ratio and the market to book value ratio.

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    104 Part II Essential Concepts in Finance

    Price to Earnings Ratio Theprice to earnings (P/E) ratio is dened as:

    P/ E RatioMarket Price per Share

    Earnings per Share=

    To calculate earnings per share (EPS), we divide net income by the number o shares

    o common stock outstanding.

    Investors and managers use the P/E ratio to gauge the uture prospects o a company.

    The ratio measures how much investors are willing to pay or claim to one dollar o

    the earnings per share o the rm. The more investors are willing to pay over the value

    o EPS or the stock, the more condence they are displaying about the rms uture

    growththat is, the higher the P/E ratio, the higher are investors growth expectations.

    Consider the ollowing marketplace data or Acme:

    Current Market Price o Acme Corporations Stock: $20.00

    2009 EPS $0.80

    P/E RatioMarket Price per Share

    Earnings per Share

    $20

    $0.8025

    =

    = =

    We see that the $20 per share market price o Acme Corporations common stock is

    25 times the level o its 2009 earnings per share ($0.80 EPS). The result o 25 indicates

    that stock traders predict that Acme has some growth in its uture. It would take 25

    years, at Acmes 2009 earnings rate, or the company to accumulate net prots o $20

    per share, the amount an investor would pay today to buy this stock.

    Market to Book Value The market to book value (M/B) ratio is the market price pershare o a companys common stock divided by the accounting book value per share

    (BPS) ratio. The book value per share ratio is the amount o common stock equity on

    the rms balance sheet divided by the number o common shares outstanding.

    The book value per share is a proxy or the amount remaining per share ater selling

    the rms assets or their balance sheet values and paying the debt owed to all creditors

    and preerred stockholders. We calculate Acmes BPS ratio, based on the ollowing

    inormation:

    Total Common Stock Equity at Year-End 2009: $ 26,000,000

    Number o Common Shares Outstanding: 4,000,000

    Book Value per Share = $6.50

    Now that we know the book value per share o Acmes stock is $6.50, we can nd

    the market to book value ratio as ollows:

    Market to Book Value RatioMarket Price per Share

    Book Value per Share

    $20

    $6.503.1

    =

    = =

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    Chapter 5 Analysis o Financial Statements

    We see that Acmes M/B ratio is 3.1. That value indicates that the market price o

    Acme common stock ($20) is 3.1 times its book value per share ($6.50).

    When the market price per share o stock is greater than the book value per share,

    analysts oten conclude that the market believes the companys uture earnings are worth

    more than the rms liquidation value. The value o the rms uture earnings minus

    the liquidation value is the going concern value o the rm. The higher the M/B ratio,

    when it is greater than 1, the greater the going concern value o the company seems to

    be. In our case, Acme seems to have positive going concern value.Companies that have a market to book value o less than 1 are sometimes considered

    to be worth more dead than alive. Such an M/B ratio suggests that i the company

    liquidated and paid o all creditors, it would have more let over or the common

    stockholders than what the common stock could be sold or in the marketplace.

    The M/B ratio is useul, but it is only a rough approximation o how liquidation and

    going concern values compare. This is because the M/B ratio uses an accounting-based

    book value. The actual liquidation value o a rm is likely to be dierent than the book

    value. For instance, the assets o the rm may be worth more or less than the value

    at which they are currently carried on the companys balance sheet. In addition, the

    current market price o the companys bonds and preerred stock may also dier rom

    the accounting value o these claims.

    Economic Value Added and Market Value AddedTwo new nancial indicators that have become popular are economic value added (EVA)

    and market value added (MVA). These indicators were developed by Stern Stewart &

    Company, a consulting rm in New York City. EVA is a measure o the amount o prot

    remaining ater accounting or the return expected by the rms investors, whereas

    MVA compares the rms current value with the amount the current owners paid or it.

    According to Stern Stewart, the use o the EVA and MVA indicators can help add value

    to a company because they help managers ocus on rewards to stockholders instead

    o traditional accounting measures.6 In the ollowing paragraphs we discuss EVA and

    MVA individually.

    Economic Value Added (EVA) As we mentioned previously, EVA is a measure o

    the amount o prot remaining ater accounting or the return expected by the rms

    investors. As such, EVA is said to be an estimate o true economic prot, or the amount

    by which earnings exceed or all short o the required minimum rate o return investors

    could get investing in other securities o comparable risk.7 The ormula to calculate

    EVA is as ollows:

    EVA = EBIT(1 TR) (IC Ka)

    where EBIT = earnings beore interest and taxes

    (i.e., operating income)TR = the eective or average income tax rate

    IC = invested capital (explained later)

    Ka = investors required rate o return on their

    investment (explained later)

    6http://www.sternstewart.com

    7Ibid.

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    106 Part II Essential Concepts in Finance

    Invested capital (IC) is the total amount o capital invested in the company. It is

    the sum o the market values o the rms equity and debt capital. Ka is the weighted

    average o the rates o return expected by the suppliers o the rms capital, sometimes

    called the weighted average cost o capital, or WACC.

    To illustrate how EVA is calculated, assume Acmes common stock is currently

    selling or $20 a share, and the weighted average return expected by investors (Ka) is

    12 percent. Also assume that the book value o debt on Acmes balance sheet is the

    same as the market values.8 Also recall rom Figures 5-1 and 5-2 that Acmes EBIT or2009 is $7,200,000; its eective income tax rate is 42 percent; and there are 4 million

    shares o common stock outstanding.

    The last term we need beore calculating Acmes EVA is invested capital (IC).

    Remember it is the sum o the market values o the rms equity and debt capital.

    Acmes IC is ound as ollows:

    Market Value o Common Equity = 4,000,000 shares $20

    = $80,000,000

    Market Value o Debt Capital = Book Value

    = Notes Payable + Long-Term Debt9

    = $3,000,000 + $15,000,000

    = $18,000,000

    Total Invested Capital (IC) = $80,000,000 + $18,000,000

    = $98,000,000

    Now we have all the amounts necessary to solve the EVA equation or Acme in 2009:

    EVA = EBIT(1 TR) (IC Ka)

    EVA = $7,200,000(1 .42) ($98,000,000 .12)

    EVA = $4,176,000 $11,760,000

    EVA = $(7,584,000)

    Acmes EVA or 2009 is negative, indicating the company did not earn a sucient

    amount during the year to provide the return expected by all those who contributed capital

    to the rm. Even though Acme had $7,200,000 o operating income and $3,184,000

    o net income in 2009, it was not enough to provide the 12 percent return expected by

    Acmes creditors and stockholders.

    Does the negative EVA result or 2009 indicate that Acme is in trouble? Not

    necessarily. Remember the negative result is only or one year, whereas it is the trendover the long term that counts. The negative result or this year could be due to any

    8This assumption is requently made in nancial analysis to ease the diculties o locating current market prices or debt

    securities. Because prices o debt securities do not tend to fuctuate widely, the assumption does not generally introduce an

    excessive amount o error into the EVA calculation.

    9Take note that total debt capital is not the same as total liabilities. Liabilities that are spontaneously generated, such as accounts

    payable and accrued expenses, are not generally included in the denition o debt capital. True debt capital is created when a

    specied amount o money is lent to the rm at a specied interest rate.

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    Chapter 5 Analysis o Financial Statements

    number o actors, all o which might be approved o by the creditors and stockholders.

    As long as Acmes average EVA over time is positive, occasional negative years are not

    cause or alarm.

    Market Value Added (MVA) Market value added (MVA) is the market value o invested

    capital (IC), minus the book value o IC.10 MVA is similar to the market to book ratio

    (M/B). MVA ocuses on total market value and total invested capital, whereas M/Bocuses on the per share stock price and per share book value. The two measures are

    highly correlated.

    For Acme in 2009:

    MVA = market value o debt plus equity book value debt plus equity

    MVA = ($18,000,000 + $80,000,000) ($18,000,000 + $26,000,000)11

    MVA = $98,000,000 $44,000,000

    MVA = $54,000,000

    Companies that consistently have high EVAs would normally have a positive MVA.

    I a company consistently has negative EVAs, it should have a negative MVA too.

    In this section we examined the key protability, liquidity, debt, asset activity, and

    market value ratios. The value o each ratio tells part o the story about the nancial

    health o the rm. Next we explore relationships among ratios.

    Relationships among Ratios: The Du Pont System

    As we discussed earlier, ratios may be used to compare one ratio to another related

    ratio. Financial analysts compare related ratios to see what specic activities add to or

    detract rom a rms perormance.

    The Du Pont system o ratio analysis is named or the company whose managers

    developed the general system. It rst examines the relationships between net incomerelative to sales and sales relative to total assets. The product o the net prot margin

    and the total asset turnover is the return on assets (or ROA). This equation, known as

    the Du Pont equation, ollows:

    Du Pont Equation

    Return on Assets = Net Prot Margin Total Asset Turnover

    Net Income

    Total Assets

    Net Income

    Sales

    Sales

    Total Assets=

    (5-1)

    Sales, on the right side o the equation, appears in the denominator o the net prot

    margin and in the numerator o the total asset turnover. These two equal sales gureswould cancel each other out i the equation were simplied, leaving net income over

    total assets on the right. This, o course, equals net income over total assets, which is

    on the let side o the equal sign, indicating that the equation is valid.

    10Notice that i you make the simpliying assumption (as we have been doing) that the market value o debt capital equals the

    book value o debt capital, then the ormula or MVA becomes the market value o equity minus the book value o equity..

    11Here again we assume the market value o debt equals the book value o debt.

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    108 Part II Essential Concepts in Finance

    This version o the Du Pont equation helps us analyze actors that contribute to a

    rms return on assets. For example, we already know rom our basic ratio analysis that

    Acme Corporations return on assets or 2009 was 6.4 percent. Now suppose you wanted

    to know how much o that 6.4 percent was the result o Acmes net prot margin or

    2009, and how much was the result o the activity o Acmes assets in 2009. Equation

    5-1, the Du Pont equation, provides the ollowing answer:

    Return on Assets Net Profit Margin Total Asset Turnover

    Net Income

    Total Assets

    Net Income

    Sales

    Sales

    Total Assets

    .064$3,184,000

    $15,000,000

    $15,000,000

    $50,000,000

    .064 .212 .3

    or

    6.4% 21.2% .3

    =

    =

    =

    =

    =

    Acme Corporation, we see, has a airly healthy net prot margin, 21.2 percent,

    but its total asset turnover is only three-tenths its sales. The .3 total asset turnover has

    the eect o cutting the 21.2 percent net prot margin by two-thirds, such that ROA is

    only 6.4 percent.

    We might see a low total asset turnover and high net prot margin in a jewelry

    store, where ew items are sold each day but high prot is made on each item sold. A

    grocery store, however, would have a low net prot margin and a high total asset turnover

    because many items are sold each day but little prot is made on each dollar o sales.

    Another version o the Du Pont equation, called the Modied Du Pont equation,

    measures how the return on equity (ROE) is aected by net prot margin, asset activity,

    and debt nancing. As shown in Equation 5-2, in the modied Du Pont equation, ROEis the product o net prot margin, total asset turnover, and the equity multiplier (the

    ratio o total assets to common equity).

    Modied Du Pont Equation

    (5-2)

    Notice that sales and total assets appear in both a numerator and a denominatorin the right side o the equation and would cancel out i the equation were simplied,

    leaving net income over equity on both the right and the let o the equal sign, indicating

    that the equation is valid.

    Return on Equity = Net Profit Margin Total Asset Turnover Equity Multiplier

    Net Income

    Common Stockholders Equity

    Net Income

    Sales

    Sales

    Total Assets

    Total Assets

    Common Stockholders Equity=

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    Chapter 5 Analysis o Financial Statements

    Solving the Modied Du Pont Equation or Acme Corporation in 2009 produces

    the ollowing:

    Return on Equity Net Profit Margin Total Asset Turnover Equity Multiplier

    Net Income

    Common Stockholders Equity

    Net Income

    Sales

    Sales

    Total Assets

    Total Assets

    Common Stockholders Equity

    $3,184,000

    $26,000,000

    $3,184,000

    $15,000,000

    $15,000,000

    $50,000,000

    $50,000,000

    $26,000,000

    .122 .212 .3 1.9

    or

    12.2% 21.2% .3 1.9

    =

    =

    =

    =

    =

    *Note: The two sides o the equation do not exactly balance because o rounding.

    Examining the preceding equation, we see that Acmes net prot margin o

    21.2 percent is greater than its 12.2 percent ROE. However, Acmes low productivityo assets ($.30 in sales or every dollar o assets employed) reduces the eect o the

    prot margin21.2% .3 = 6.4%. I no other actors were present, Acmes ROE would

    be 6.4 percent.

    Now the equity multiplier comes into play. The equity multiplier indicates the

    amount o nancial leverage a rm has. A rm that uses only equity to nance its assets

    should have an equity multiplier that equals 1.0. To arrive at this conclusion, recall the

    basic accounting ormulatotal assets = liabilities + equity. I a rm had no debt on

    its balance sheet, its liabilities would equal zero, so equity would equal total assets. I

    equity equaled total assets, then the equity multiplier would be 1. Multiplying 1 times

    any other number has no eect, so in such a situation ROE would depend solely on net

    prot margin and total asset turnover.I a rm does have debt on its balance sheet (as Acme does), it will have assets greater

    than equity and the equity multiplier will be greater than 1. This produces a multiplier

    eect that drives ROE higher (assuming net income is positive) than can otherwise be

    accounted or by net prot margin and asset turnover.12

    Acmes equity multiplier o 1.9 indicates that Acme has assets that are 1.9 times

    its equity. This has the eect (called the leverage eect) o boosting Acmes return on

    equity rom 6.4 percent to 12.2 percent. The leverage eect, caused by debt o $24

    million shown on Acmes balance sheet, signicantly alters Acmes ROE.

    12We will discuss leverage in more detail in Chapter 13.

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    110 Part II Essential Concepts in Finance

    In this section we reviewed basic ratios, and analyzed relationships o one ratio

    to another to assess the rms nancial condition. Next we will investigate how ratio

    analysis can be used to compare trends in a rms perormance and to compare the

    rms perormance to other rms in the same industry.

    Trend Analysis and Industry ComparisonsRatios are used to compare a rms past and present perormance and its industry

    perormance. In this section we will examine trend analysis and industry comparison.

    Comparing a ratio or one year with the same ratio or other years is known as trend

    analysis. Comparing a ratio or one company with the same ratio or other companies

    in the same industry is industry comparison.

    Trend AnalysisTrend analysis helps nancial managers and analysts see whether a companys current

    nancial situation is improving or deteriorating. To prepare a trend analysis, compute

    the ratio values or several time periods (usually years) and compare them. Table 5-1shows a ve-year trend or Acme Corporations ROA.

    As Table 5-1 shows, Acme Corporations ROA rose substantially between 2006

    and 2009, with the largest growth occurring between 2006 and 2007. Overall, the

    trend analysis indicates that Acmes 2009 ROA o 6.4 percent is positive, compared

    to earlier years.

    Usually, analysts plot ratio value trends on a graph to provide a picture o the results.

    Figure 5-3, on the next page, is a graph o Acmes 20052009 ROA ratios.

    The ve-year generally upward trend in ROA, depicted in Figure 5-3, indicates that

    Acme Corporation increased the amount o prot it generated rom its assets.

    Trend analysis is an invaluable part o ratio analysis. It helps management spot a

    deteriorating condition and take corrective action, or identiy the companys strengths.

    By assessing the rms strengths and weaknesses, and the pace o change in a strengthor weakness, management can plan eectively or the uture.

    Industry Comparisons

    Another way to judge whether a rms ratio is too high or too low is to compare it with

    the ratios o other rms in the industry (this is sometimes called cross-sectional analysis,

    or benchmarking). This type o comparison pinpoints deviations rom the norm that

    may indicate problems.

    Table 5-2 shows a comparison between Acme Corporations ROA ratio and the

    average ROA in Acme Corporations industry or 2009. It shows that, compared with

    other rms in Acmes industry, Acme achieved an above-average ROA in 2009. Only

    Company B managed to do better than Acme.

    Interactive Module

    Go to DownloadableCompanion Material,chapter 5. Then go to the

    Interactive Spreadsheetor chapter 5. Follow theinstructions there. Whatdo the ratios tell us? Howare the ratios connected?Note how the numbers areobtained rom the nancialstatements.

    Table 5-1 Acme Corporation ROA, 20052009

    2005 2006 2007 2008 2009

    ROA 1.8% 2.2% 2.6% 4.1% 6.4%

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    Chapter 5 Analysis o Financial Statements

    Figure 5-3 Acme

    Corporation Five-YearTrend in ROA

    Benchmarking allows analysts to put the value o a rms ratio in the context o

    its industry. For example, Acmes ROA o 6.4% is higher than average or its industry,

    thus Acme would be looked upon avorably. In another industry, however, the average

    ROA might be 10 percent, causing Acmes 6.4% to appear much too low. Whether a

    ratio value is good or bad depends on the characteristics o the industry. By putting the

    ratio in context, analysts compare apples to apples and not apples to oranges.Notedo not all into the trap o thinking that a company does not have problems

    just because its ratios are equal to the industry averages. Maybe the whole industry is

    in a slump! When a ratio equals the industry average it simply means the company is

    average in the area that ratio measures.

    8%

    6%

    4%

    2%

    0%

    2%

    4%2005 2006 2007 2008 2009

    Table 5-2 Acme Corporation Cross-Sectional Analysis o ROA 2009

    Company ROAAcme Corporation 6.4%

    Company A 1.0%

    Company B 7.1%

    Company C 0.9%

    Industry Average 3.9%

    (ACME + A + B + C) 4 = 3.9

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    112 Part II Essential Concepts in Finance

    Summary Analysis: Trend and IndustryComparisons Together

    A complete ratio analysis o a company combines both trend analysis and industry

    comparisons. Table 5-3 shows all the ratios presented in this chapter or Acme

    Corporation or 2005 through 2009, along with the industry averages or those ratios.

    (The industry averages are labeled IND in the table.)First, lets review Acmes protability ratios compared with the industry average

    or 2005 to 2009. In 2005 and 2006, Acme Corporation had negative net income. This

    gave a negative value to the net prot margin, return on assets, and return on equity

    or each o these years (because net income is the numerator or each ratio). There was

    steady improvement, however, in the prot ratios rom 2005 to 2009.

    Acme Corporation had lower gross prot, operating prot, and net prot margins

    than the industry norm or that ve-year time period except or the 2009 operating and

    net prot margins. For 2005 and 2006, Acme also had a lower return on assets ratio

    than the industry average. As the summary analysis shows, the 20052009 ROAs are

    the result o higher asset turnover ratios.

    The return on equity gures paint a telling story over this ve-year period. From2005 to 2007, Acme Corporation had a much lower return on equity than the average

    rm in its industry. In 2005 and 2006, these gures were negative, whereas the industry

    norms were positive. In 2007 and 2009, however, Acme Corporation had a much higher

    return on equity than the average rm in its industry.

    Next, we examine the liquidity ratios. The current ratio, 2.2, has been rising each

    year through 2009, when it was 3.3. Having two times or more the amount o current

    assets as current liabilities is a good target or most companies. Because the industry

    norm or the current ratio was below the value Acme Corporation had each o these

    years, Acme had a comparatively high liquidity position.

    The quick ratio stayed near the industry norm throughout this period until it spiked to

    2.2 in 2009. This means that when inventory is subtracted rom total current assets, Acme

    Corporations liquidity looked steady. Again, however, 2009s value (2.2 or Acme versus1.2 or the industry norm) suggests that management should watch liquidity in 2010.

    Acme had a high debt load until 2008. The debt to total asset ratio was consistently

    above 80 percent, whereas the industry norm or this ratio was 62 percent or less rom

    2005 to 2008. A high debt load magnies the changes in the return on equity ratio values.

    The times interest earned ratio shows that Acme Corporation barely covered its

    interest expense with its operating income until 2009. The value o this ratio was slightly

    more than 1, except or 2009, when it jumped to 4.2.

    Now lets look at the asset activity ratios. The average collection period has been

    signicantly lower or Acme than or the average rm in its industry. It appears that

    Acme is doing a better than average job o collecting its accounts receivable.

    The inventory turnover ratio was erratic over this ve-year period. The fuctuationssuggest that Acme did not match its inventory to its demand or products. The numbers

    suggest that Acmes managers should have studied its inventory control policies to

    look or ways to match demand and inventory more closely. There was a big increase

    in 2009. More about this in Chapter 19.

    The total asset turnover ratio was consistently just above the industry norm. This

    helped the return on assets ratio during the years when net income was positive, as

    described earlier.

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    Chapter 5 Analysis o Financial Statements

    Table 5-3 Five-Year Ratio Analysis or Acme Corporation

    Ratios 2005 2006 2007 2008 20

    Proftability Ratios

    Gross Prot Margin Acme 36.2% 38.9% 42.8% 58.9% 66

    (Gross Prot Sales) Ind 55.7% 58.9% 62.2% 66.0% 68

    Operating Prot Margin Acme 14.3% 16.5% 18.6% 28.9% 48

    (EBIT Sales) Ind 34.2% 35.1% 37.5% 40.0% 42

    Net Prot Margin Acme 8.5% 5.8% 3.4% 7.8% 21

    (Net Income Sales) Ind 4.3% 6.4% 10.2% 11.5% 13

    Return on Assets (ROA) Acme 1.8% 2.2% 2.6% 4.1% 6

    (Net Income Total Assets) Ind 1.2% 1.8% 2.2% 2.5% 2

    Return on Equity (ROE) Acme 14.6% 7.5% 2.8% 8.3% 12

    (Net Income Common Equity) Ind 3.9% 4.4% 5.1% 5.6% 7

    Liquidity Ratios

    Current Ratio Acme 2.2 2.2 2.3 2.6 3

    (Current Assets Current Liabilities) Ind 2.0 2.0 2.1 2.2 2

    Quick Ratio Acme 1.0 1.2 1.3 1.4 2

    (Current Assets Less Inventory Current Liabilities) Ind 1.1 1.0 1.1 1.1 1

    Debt Management Ratios

    Debt to Total Assets Acme 81.0% 81.0% 82.0% 55.1% 48

    (Total Debt Total Assets) Ind 62.0% 59.0% 57.0% 58.0% 60

    Times Interest Earned Acme 1.1 1.2 1.2 1.4 4

    (EBIT Interest Expense) Ind 3.7 3.8 4.0 4.2 4

    Asset Activity Ratios

    Average Collection Period (days) Acme 33.8 31.5 30.1 28.4 24(Accounts Receivable Average Daily Credit Sales) Ind 40.2 39.8 38.4 37.3 40

    Inventory Turnover (on sales) Acme 0.4 0.5 0.8 0.5 1

    (Sales Inventory) Ind 0.6 0.7 0.7 0.7 0

    Total Asset Turnover Acme 0.3 0.2 0.2 0.2 0

    (Sales Total Assets) Ind 0.2 0.2 0.1 0.2 0

    Market Value Ratios

    PE Ratio Acme 80.0 36.0 25

    (Market Price per Share EPS) Ind 15.0 17.0 19.0 15.0 16

    Market to Book Ratio Acme 1.3 1.6 1.8 2.0 2

    (Market Price per Share Book Value per Share) Ind 2.1 2.2 1.9 2.0 2

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    Finally, we turn to the market value ratios. Acme had no meaningul P/E ratios

    or 2005 and 2006 because net income and, thereore, EPS, were negative. The P/E

    ratio o 80 in 2007 shows investors had high expectations about Acmes uture growth,

    but these expectations moderated in the next two years as the company matured. The

    market to book value ratio shows an upward trend over the ve-year period showing

    that investors increasingly valued Acmes uture earnings potential above the companys

    asset liquidation value.

    We have just nished a complete ratio analysis o Acme Corporation, includingexaminations o the companys protability, liquidity, debt management, asset activity,

    and market value ratios. To conduct the analysis, we combined trend and industry analysis

    so we could see how Acme perormed over time and how it perormed relative to its

    industry. Managers inside the company can use the results o the analysis to support

    proposed changes in operations or organization; and creditors and investors outside the

    company can use the results to support decisions about lending money to the company

    or buying its stock.

    Locating Inormation about Financial Ratios

    Ratio analysis involves a air amount o research. Beore analysts can calculate all

    the ratios, they must locate the underlying, raw nancial data. Analysts can gather

    inormation about publicly traded corporations at most libraries, on CD-ROM databases,

    and on the Internet.

    A number o organizations publish nancial data about companies and industries.

    Many publications contain ratios that are already calculated. Table 5-4 contains a list

    o publications that nancial analysts nd useul when they are researching companies

    and industries. Many o them are available at local libraries.

    Whats NextIn this chapter we learned how to calculate and apply nancial ratios to analyze the

    nancial condition o the rm. In Chapter 6 we will see how to use analyses to orecast

    and plan or the companys uture.

    Summary

    1. Explain how nancial ratio analysis helps assess the health o a company.

    Just as doctors assess a patients health, nancial analysts assess the nancial health o

    a rm. One o the most powerul assessment tools is nancial ratio analysis. Financialratios are comparative measures that allow analysts to interpret raw accounting data

    and identiy strengths and weaknesses o the rm.

    2. Compute protability, liquidity, debt, asset activity, and market value ratios.

    Protability, liquidity, debt, asset activity, and market value ratios show dierent aspects

    o a rms nancial perormance. Protability, liquidity, debt, and asset activity ratios

    use inormation rom a rms income statement or balance sheet to compute the ratios.

    Market value ratios use market and nancial statement inormation.

    114 Part II Essential Concepts in Finance

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    Chapter 5 Analysis o Financial Statements

    Protability ratios measure how the rms returns compare with its sales, asset

    investments, and equity. Liquidity ratios measure the ability o a rm to meet its

    short-term obligations. Debt ratios measure the rms debt nancing and its abilityto pay o its debt. Asset activity ratios measure how eciently a rm uses its assets.

    Finally, market value ratios measure the markets perception about the uture earning

    power o a business.

    The Du Pont system analyzes the sources o ROA and ROE. Two versions o the

    Du Pont equation were covered in this chapter. The rst analyzes the contributions o

    net prot margin and total asset turnover to ROA. The second version analyzes how the

    infuences o net prot margin, total asset turnover, and leverage aect ROE.

    Table 5-4 Sources o Financial Inormation

    Business news, articles,market data, stock, bond,mutual und price quotes

    Business news, articles

    Data on the economy,industries; many nancialstatistics (interest rates,infation, etc.)

    Summary data aboutindustries, companies; adviceon industries, stocks; analysisand orecasts

    Data on companies andindustries

    Company perormance:corporate nancial data

    Inormation about bonds

    Inormation about mutualunds

    Variety o business andnancial news andinormation (some requirepaid subscriptions)

    Newspapers

    Magazines

    Bound publications

    Investment advisorypublications

    Computer databases

    Bound publications

    Bound publications

    Web

    The Wall Street Journal, Barrons, USA Today

    Forbes, Fortune, Business Week, Money Magazine

    US Industrial Outlook, Standard & Poors Statistical Surveys,Standard & Poors Industry Surveys, Federal Reserve Bulletin,World Almanac, Statistical Abstract of the United States, BusinConditions Digest(contains leading, lagging, and coincidentindicators o the economy), Economic Report of the President

    Value-Line Investment Survey(each company report appears opage), Standard & Poors Outlook

    Compustat PC Plus CD-ROM, Value Screen

    Annual reports rom the company (can oten be obtained by prom the company), Standard & Poors Stock Reports (versionsor the NYSE, AMEX, and OTC markets), Standard & PoorsCorporation Records (contains in-depth reports about companiincluding nancial statement data), Moodys Handbook of CoStocks (similar to the S&P Stock Reports), Moodys IndustrialManual, Moodys Bank & Finance Manual, Moodys OTC MaMoodys Public Utility Manual, Moodys Transportation ManuaMoodys International Manual(all these Moodys manuals conin-depth reports on companies)

    Moodys Bond Record, Moodys Bond Survey

    Morningstar Mutual Funds (similar to Value-Line but or mutualunds), Weisenbergers Management Results, WeisenbergersCurrent Performance & Dividend Record(similar to Moodysmanuals but covers mutual unds)

    http://www.bloomberg.com, http://www.compustat.com, httpwww.valueline.com , http://www.morningstar.com , http://pubwsj.com/home.html, http://money.cnn.com, http://yahoo.comBusiness_and_Economy/Finance_and_Investment, http://wwwgov/edgar.shtml, http://www.quicken.com, http://www.wsrn

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    116 Part II Essential Concepts in Finance

    3. Compare nancial inormation over time and among companies.

    Trend analysis compares past and present nancial ratios to see how a rm has perormed

    over time. Industry analysis compares a rms ratios with the ratios o companies in

    the same industry. Summary analysis, one o the most useul nancial analysis tools,

    combines trend and industry analysis to measure how a company perormed over time

    in the context o the industry.

    4. Locate ratio value data or specic companies and industries.

    A number o organizations publish nancial data about companies and industries.

    Many publications contain ratios that are already calculated. Table 5-4 contains a list

    o publications that nancial analysts nd useul when they are researching companies

    and industries.

    Equations Introduced in This Chapter

    Proftability Ratios:

    Gross Profit MarginGross Profit

    Sales=

    Operating Profit MarginEBIT

    Sales=

    Net Profit MarginNet Income

    Sales=

    Return on AssetsNet Income

    Total Assets=

    Return on EquityNet Income

    Common Stockholders Equity=

    Liquidity Ratios:

    Current RatioCurrent Assets

    Current Liabilities=

    Quick RatioCurrent Assets Less Inventory

    Current Liabilities=

    Debt Ratios:

    Debt to Total AssetsTotal Debt

    Total Assets=

    Times Interest EarnedEBIT

    Interest Expense=

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    Chapter 5 Analysis o Financial Statements

    Asset Activity Ratios:

    Average Collection PeriodAccounts Receivable

    Average Daily Credit Sales

    =

    Inventory TurnoverSales

    Inventory=

    Total Asset Turnover

    Sales

    Total Assets=

    Market Value Ratios:

    P/ E Ratio

    Market Price per Share

    Earnings per Share=

    Market to Book Value Ratio

    Market Price per Share

    Book Value per Share=

    Economic Value Added (EVA) and Market Value Added (MVA):

    EVA = EBIT(1 TR) (IC Ka)

    MVA = market value o debt plus equity

    book value debt plus equity

    Equation 5-1. The Du Pont Formula:

    Return on Assets = Net Prot Margin Total Asset Turnover

    Net Income

    Total Assets

    = Net Income

    Sales

    Sales

    Total Assets

    Equation 5-2. The Modied Du Pont Formula:

    Return on Equity = Net Profit Margin Total Asset Turnover Equity Multiplier

    Net Income

    Common Stockholders Equity

    Net Income

    Sales

    Sales

    Total Assets

    Total Assets

    Common Stockholders Equity=

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    118 Part II Essential Concepts in Finance

    Sel-Test

    ST-1 De Marco Corporation has total assets o $5

    million and an asset turnover ratio o 4. I net

    income is $2 million, what is the value o the

    net prot margin?

    ST-2 Francisco Company has current assets o

    $50,000. Total assets are $200,000; and long-

    term liabilities and common stock collectively

    total $180,000. What is the value o the current

    ratio?

    ST-3 I one-hal the current assets in ST-2 consist o

    inventory, what is the value o the quick ratio?

    ST-4 Sheth Corporation has a return on assets ratio

    o 6 percent. I the debt to total assets ratio is

    .5, what is the rms return on equity?

    ST-5 Mitra Company has a quick ratio value o 1.5.

    It has total current assets o $100,000 and

    total current liabilities o $25,000. I sales are

    $200,000, what is the value o the inventory

    turnover ratio?

    ST-6 Yates Corporation has total assets o $500,000.

    Its equity is $200,000. What is the companys

    debt to total asset ratio?

    ST-7 Pendell Company has total sales o $4 million.

    One-ourth o these are credit sales. The

    amount o accounts receivable is $100,000.

    What is the average collection period or the

    company? Use a 365-day year.

    Review Questions

    1. What is a nancial ratio?

    2. Why do analysts calculate nancial ratios?

    3. Which ratios would a banker be most interested in

    when considering whether to approve an applica-

    tion or a short-term business loan? Explain.

    4. In which ratios would a potential long-term bond

    investor be most interested? Explain.

    5. Under what circumstances would market to book

    value ratios be misleading? Explain.

    6. Why would an analyst use the Modied Du Pont

    system to calculate ROE when ROE may be calcu-

    lated more simply? Explain.

    7. Why are trend analysis and industry comparisonimportant to nancial ratio analysis?

    Build Your Communication Skills

    CS-1 Research a publicly traded company that has

    a presence in your community. Assess the

    nancial health o this company in the areas o

    protability, liquidity, debt, and asset activity.

    Write a report o your ndings. Include in

    your report a discussion o the strengths and

    weaknesses o the company, key trends, and

    how the companys ratios compare with other

    companies in its industry.

    CS-2 You have just been given a job as a loan

    ocer. It is your job to evaluate business loan

    applications. Your boss would like you to

    prepare a new set o guidelines to be used by

    the bank to evaluate loan requests, leading to

    the approval or denial decision.

    Prepare a loan application packet. Include

    the specic quantitative and qualitative

    inormation you would want an applicant or

    a loan to provide to you. Explain in a brie

    report, oral or written, how you would use the

    requested inormation to decide whether a loan

    should be approved.

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    Chapter 5 Analysis o Financial Statements

    Problems

    ProftabilityRatios

    Liquidity Ratio

    Asset ActivityRatios

    Asset Activity

    Ratios

    Market ValueRatios

    5-1. The 2009 income statement or TeleTech is shown here:

    Net Sales $35,000,000

    Cost o Goods Sold 15,000,000

    Gross Prot 20,000,000Selling and Admin. Expenses 1,000,000

    Depreciation 3,000,000

    Operating Income (EBIT) 16,000,000

    Interest Expense 2,500,000

    Income beore Taxes (EBT) 13,500,000

    Taxes (40%) 5,400,000

    Net Income 8,100,000

    Calculate the ollowing:

    a. Gross prot margin

    b. Operating prot margin

    c. Net prot margin

    5-2. Rallys has notes payable o $500, long-term debt o $1,900, inventory o

    $900, total current assets o $5,000, accounts payable o $850, and accrued

    expenses o $600. What is Rallys current ratio? What is its quick ratio?

    5-3. XYZ Corporation has annual credit sales equal to $5 million, and its

    accounts receivable account is $500,000. Calculate the companys average

    collection period.

    5-4. In 2009, TeleTech had sales o $35 million. Its current assets are $15 million,

    $12 million is in cash, accounts receivable are $600,000, and net xed assetsare $20 million. What is TeleTechs inventory turnover? What is its total

    asset turnover?

    5-5. The ollowing data apply to Ramchander Corporation:

    Total Common Stock Equity at Year-End 2009 $4,500,000

    Number o Common Shares Outstanding 650,000

    Market Price per Share $25

    Calculate the ollowing:

    a. Book value per shareb. Market to book value ratio

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    120 Part II Essential Concepts in Finance

    Problems 56 to 511 reer to the consolidated income statement and consolidated

    balance sheet o Pinewood Company and Subsidiaries that ollow.

    Pinewood Company and SubsidiariesIncome Statement for 2009 (000 dollars)

    Sales $ 94,001

    Cost o Goods Sold 46,623Gross Prot 47,378

    Selling and Administrative Expenses 28,685

    Depreciation and R&D Expense (both tax deductible) 5,752

    EBIT or Operating Income 12,941

    Interest Expense 48

    Interest Income 427

    Earning Beore Taxes (EBT) 13,320

    Income Taxes 4,700

    Net Income (NI) 8,620

    Earnings per Share 1.72

    Pinewood Company and SubsidiariesBalance Sheet as of End of 2009 (000 dollars)

    Assets:

    Cash $ 5,534

    Marketable Securities 952

    Accounts Receivable (gross) 14,956

    Less: Allowance or Bad Debts 211

    Accounts Receivable (net) 14,745

    Inventory 10,733

    Prepaid Expenses 3,234

    Plant and Equipment (gross) 57,340

    Less: Accumulated Depreciation 29,080

    Plant and Equipment (net) 28,260

    Land 1,010

    Long-Term Investments 2,503

    Total Assets 66,971

    Liabilities:

    Accounts Payable 3,253

    Notes Payable

    Accrued Expenses 6,821

    Bonds Payable 2,389

    Stockholders Equity:

    Common Stock 8,549

    Retained Earnings 45,959

    Total Liabilities and Equity 66,971

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    Chapter 5 Analysis o Financial Statements

    5-6. Calculate the ollowing protability ratios or 2009.

    a. Gross prot margin

    b. Operating prot margin

    c. Net prot margin

    d. Return on assets

    e. Return on equity

    Comment on net prot margin and return on assets ratios i the industry average

    or these two ratios are 5 percent and 14 percent, respectively.

    5-7. Calculate the ollowing liquidity ratios or the end o 2009.

    a. Current ratio

    b. Quick ratio

    Comment on the companys ability to pay o short-term debts.

    5-8. Calculate the ollowing debt ratios or the end o 2009.

    a. Debt to total assets

    b. Times interest earnedWould a banker agree to extend a loan to Pinewood? Explain.

    5-9. Calculate the ollowing asset activity ratios or the end o 2009.

    a. Average collection period

    b. Inventory turnover

    c. Total asset turnover

    Comment on Pinewoods asset utilization.

    5-10. Construct and solve Pinewoods Modied Du Pont equation or 2009. Use

    the end o 2009 asset gures. Comment on the companys sources o ROE.

    5-11. a. Calculate the economic value added (EVA) or Pinewood,

    assuming that the rms income tax rate is 35 percent, the

    weighted average rate o return expected by the suppliers o the

    rms capital is 10 percent, and the market price o the rms

    stock is $15. There are 5 million shares outstanding.

    b. Comment on your results. What does the EVA value that you calculated

    indicate?

    c. Calculate the market value added (MVA) or Pinewood.

    d. Comment on your results. What does the MVA value that you calculated

    indicate?

    ProftabilityRatios

    Liquidity Ratio

    Debt ManageRatios

    Asset ActivityRatios

    ModifedDu Pont Equa

    EVA/MVA

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    Chapter 5 Analysis o Financial Statements

    Balance SheetDec. 31, 2009

    Assets:

    Cash $ 350

    Marketable Securities 300

    Accounts Receivable 400

    Inventory 680

    Prepaid Expenses 200

    Total Current Assets 1,930

    Fixed Assets, Gross 63,000

    Less Accumulated Depreciation (42,000 )

    Fixed Assets, Net 21,000

    Total Assets $ 22,930

    Liabilities and Equity:

    Accounts Payable $ 740

    Notes Payable 630

    Accrued Expenses 350

    Total Current Liabilities 1,720

    Long-Term Debt 6,000

    Total Liabilities 7,720

    Common Stock 3,000

    Capital in Excess o Par 6,610

    Retained Earnings 5,600

    Total Common Equity 15,210

    Total Liabilities and Equity $ 22,930

    The total invested capital o the rm is $33,630.

    a. Calculate the EVA or T & J Corporation, assuming that the rms incometax rate is 35 percent, the weighted average rate o return expected by the

    suppliers o the rms capital is 12 percent, and the market price o the

    rms stock is $9.

    b. Comment on your results. What does the EVA value that you calculated

    indicate?

    c. Calculate the MVA or the T & J Corporation.

    d. Comment on your results. What does the MVA value that you calculated

    indicate?

    5-14. The ollowing nancial data relate to ABC Textile Companys business

    in 2009.

    Sales $ 1,000,000

    Net Income $80,000

    Total Assets $500,000

    Debt to Total Assets Ratio 0.5 or 50%

    a. Construct and solve the Du Pont and Modied Du Pont equations

    or ABC.

    Du Pont Equa

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    124 Part II Essential Concepts in Finance

    b. What would be the value o the ROE ratio i the debt to total asset ratio

    were 70 percent?

    c. What would be the value o the ROE ratio i the debt to total asset ratio

    were 90 percent?

    d. What would be the value o the ROE ratio i the debt to total asset ratio

    were 10 percent?

    5-15. From the values o the dierent ratios that ollow, calculate the missing

    balance sheet items and complete the balance sheet.

    Sales $100,000

    Average Collection Period 55 days

    Inventory Turnover 15

    Debt to Assets Ratio .4 or 40%

    Current Ratio 3

    Total Asset Turnover 1.6

    Fixed Asset Turnover 2.9

    Assets Liabilities + Equity

    Cash $6,000 Accounts Payable $ 6,000

    Accounts Receivable Notes Payable

    Inventory Accrued Expenses 600

    Prepaid Expenses Total Current Liabilities

    Total Current Assets Bonds Payable

    Fixed Assets Common Stock 16,000

    Retained Earnings

    Total Assets Total Liabilities + Equity

    5-16. Given the partial nancial statement inormation rom La StradaCorporation, a circus equipment supplier, calculate the return on equity ratio.

    Total Assets $10,000

    Total Liabilities 6,000

    Total Sales 5,000

    Net Prot Margin 10%

    5-17. What is the current ratio o Ah, Wilderness! Corporation, given the ollowing

    inormation rom its end o 2009 balance sheet?

    Current Assets $ 5,000Long-Term Liabilities 18,000

    Total Liabilities 20,000

    Total Equity 30,000

    5-18. Rocinante, Inc., manuactures windmills. What is Rocinantes total asset

    turnover i its return on assets is 12 percent and its net prot margin is

    4 percent?

    FinancialRelationships

    FinancialRelationships

    Liquidity Ratios

    Du Pont Equation

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    Chapter 5 Analysis o Financial Statements

    Use the ollowing inormation to answer questions 5-19 to 5-25.

    In 2009, Iron Jay opened a small sporting goods retail store called Iron Jays Sports

    Stu (IJSS). It immediately became very popular, and growth was only limited by

    the amount o capital Jay could generate through prots and loans. Jays nancial

    manager advised him to incorporate. His manager said that by selling stock, Jay

    would have the necessary capital to expand his business at an accelerated pace.

    Answer the ollowing questions relating to Iron Jays Sports Stu.

    5-19. The management team at IJSS is looking toward the uture. They want to

    maintain a gross prot margin o 50 percent. I the estimate or net sales

    in 2010 is $5 million, how much gross prot will be necessary in 2010 to

    maintain this ratio?

    5-20. Using the data in 5-19, i the management team estimated $200,000 in

    selling and administration expenses and $50,000 in depreciation expenses

    or 2010, with net sales o $5 million, what operating prot margin can

    they expect?

    5-21. What must net income be in 2010 i IJSS also wants to maintain a net protmargin o 20 percent on net sales o $5 million?

    5-22. What will IJSSs return on assets be i its total assets at the end o 2010

    are estimated to be $20 million? Net sales are $5 million, and the net prot

    margin is 20 percent in that year.

    5-23. IJSS management knows the astute owners o IJSS stock will sell their stock

    i the return on stockholders equity investment (return on equity ratio) drops

    below 10 percent. Total stockholders equity or the end o 2010 is estimated

    to be $15 million. How much net income will IJSS need in 2010 to ulll the

    stockholders expectation o the return on equity ratio o 10 percent?

    5-24. O the $20 million in total assets estimated or the end o 2010, only

    $2 million will be classied as noncurrent assets. I current liabilities are

    $4 million, what will IJSSs current ratio be?

    5-25. Inventory on the balance sheet or the end o 2010 is expected to be $3

    million. With total assets o $20 million, noncurrent assets o $2 million, and

    current liabilities o $4 million, what will be the value o IJSSs quick ratio?

    5-26. Given $20 million in total assets, $14 million in total stockholders equity,

    and a debt to total asset ratio o 30 percent or Folson Corporation, what will

    be the debt to equity ratio?

    5-27. I total assets are $20 million, noncurrent assets are $2 million, inventory is

    $3 million, and sales are $5 million or Toronto Brewing Company, what is

    the inventory turnover ratio?

    Proftability R

    Proftability R

    Proftability R

    ModifedDu Pont Equa

    Proftability R

    Liquidity Ratio

    Liquidity Ratio

    Debt Ratios

    Asset ActivityRatios

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    126 Part II Essential Concepts in Finance

    5-28. I the net prot margin o Dobies Dog Hotel is maintained at 20 percent and

    total asset turnover ratio is .25, calculate return on assets.

    5-29. The ollowing data are rom Saratoga Farms, Inc., 2009 nancial statements.

    Sales $2,000,000

    Net Income 200,000

    Total Assets 1,000,000Debt to Total Asset Ratio 60%

    a. Construct and solve the Du Pont and Modied Du Pont equations or

    Saratoga Farms.

    b. What would be the impact on ROE i the debt to total asset ratio were

    80 percent?

    c. What would be the impact on ROE i the debt to total asset ratio were

    20 percent?

    5-30. The ollowing nancial inormation is rom two successul retail operations

    in Niagara Falls. Rose and George Loomis own Notoriously Niagara, alavish jewelry store that caters to the personal jet-set crowd. The other

    store, Niagaras Notions, is a big hit with the typical tourist. Polly and Ray

    Cutler, the owners, specialize in inexpensive souvenirs such as postcards,

    mugs, and T-shirts.

    Notoriously Niagara Niagaras Notions

    Sales $ 500,000 Sales $ 500,000

    Net Income 100,000 Net Income 10,000

    Assets 5,000,000 Assets 500,000

    a. Calculate the net prot margin or each store.

    b. Calculate the total asset turnover or each store.

    c. Combine the preceding equations to calculate the return on assets or each

    store.

    d. Why would you expect Notoriously Niagaras net prot margin to be

    higher than Niagaras Notions, considering both stores had annual sales o

    $500,000 and the same gure or return on assets?

    5-31. Thunder Alley Corporation supplies parts or Indianapolis-type race cars.

    Current market price per share o Thunder Alleys common stock is $40.

    The latest annual report showed net income o $2,250,000 and total common

    stock equity o $15 million. The report also listed 1,750,000 shares o

    common stock outstanding. No common stock dividends are paid.

    a. Calculate Thunder Alleys earnings per share (EPS).

    b. Calculate Thunder Alleys price to earnings (P/E) ratio.

    c. Calculate Thunder Alleys book value per share.

    d. What is Thunder Alleys market to book ratio?

    e. Based on this inormation, does the market believe that the uture earning

    power o Thunder Alley justies a higher value than could be obtained by

    liquidating the rm? Why or why not?

    Du Pont Equation

    Du Pont Equation

    Various Ratios

    Various Ratios

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    Chapter 5 Analysis o Financial Statements

    5-32. Carrie White, the new nancial analyst o Golden Products, Inc., has been

    given the task o reviewing the perormance o her company over three

    recent years against the ollowing industry inormation (gures in $000):

    Net Current Current Total Total Year Income Assets Liabilities Assets Liabilities Sales

    2007 $400 $500 $530 $3,800 $2,600 $4,000

    2008 425 520 510 3,900 2,500 4,500

    2009 440 550 510 4,000 2,400 4,700

    The industry averages are

    NI/Sales Current Ratio Total Assets Turnover

    9.42% 1.13 2.00

    Should Carrie be critical o her companys perormance?

    5-33. Johnny Hooker, another nancial analyst o Golden Products, Inc., is

    working with the same yearly gures shown in 5-32, but he is trying tocompare the perormance trend using another set o industry averages:

    The industry averages are

    Fixed Return Debt to Return Asset Turnover on Assets Assets Ratio on Equity

    1.33 11.00% 0.60 26%

    Should Johnny be appreciative o his companys perormance?

    5-34. Vernon Pinkby, the nancial analyst reporting to the chie nancial ocer

    o Aluab Aluminum Company, is comparing the perormance o the

    companys our separate divisions based on prot margin and return on

    assets. The relevant gures ollow (gures in $000):

    Mining Smelting Rolling Extrusion

    Net Income $ 500 $ 2,600 $ 7,000 $ 2,500

    Sales 15,000 30,000 60,000 25,000

    Total Assets 12,000 25,000 39,000 18,000

    a. Compare prot margin ratios o the our divisions.

    b. Compare return on assets ratios o the our divisions.

    c. Compute prot margin o the entire company.

    d. Compute return on assets o the entire company.

    Industry

    Comparisons

    Industry

    Comparisons

    Probability Ra

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    128 Part II Essential Concepts in Finance

    5-35. From the values o the dierent ratios given, calculate the missing balance

    sheet and income statement items o National Glass Company.

    Average Collection Period 48.67 days

    Inventory Turnover 9x

    Debt to Asset Ratio .4 or 40%

    Current Ratio 1.6250

    Total Asset Turnover 1.5

    Fixed Asset Turnover 2.647

    Return on Equity 0.1933 or 19.33%

    Return on Assets 0.116 or 11.6%

    Operating Prot Margin 13.33%

    Gross Prot Margin 48.89%

    National Glass Company Income Statementfor 2009 (000 dollars)

    Sales $45,000

    Cost o Goods SoldGross Prot

    Selling and Administrative Expenses

    Depreciation Expense 3,000

    Operating Income (EBIT)

    Interest Expense

    Earnings beore Taxes (EBT)

    Income Taxes (T = 40%) 2,320

    Net Income (NI)

    National Glass Company Balance Sheet

    as of End 2009Assets: $

    Cash

    Accounts Receivable (gross)

    Inventory

    Plant and Equipment (net)

    Land 1,000

    Liabilities:

    Accounts Payable 2,000

    Notes Payable

    Accrued Expenses 3,000Bonds Payable

    Stockholders Equity:

    Common Stock 4,000

    Retained Earnings

    Challenge Problem

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    Chapter 5 Analysis o Financial Statements

    5-36. Kingston Tools Company (KTC) manuactures various types o high-quality

    punching and deep-drawing press tools or kitchen appliance manuacturers.

    Horner Smith, the nance manager o KTC, has submitted a justication to

    support the application or a short-term loan rom the Queensville Interstate

    Bank (QIB) to nance increased sales. The consolidated income statement

    and balance sheet o KTC, submitted with the justication to QIB, ollow.

    Kingston Tools Company Income Statementfor 2009 and 2010 (000 dollars)

    2009 2010

    Sales $40,909 $45,000

    Cost o Goods Sold 20,909 23,000

    Gross Prot 20,000 22,000

    Selling and Administrative Expenses 11,818 13,000

    Depreciation 2,000 3,000

    Operating Income (EBIT) 6,182 6,000

    Interest Expense 400 412

    Earnings beore Taxes (EBT) 5,782 5,588Income Taxes (@ 40%) 2