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Transcript of Gallagher 5e.c5
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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