Who is able to complete this discussion?

3

Financial Analysis

LEARNING OBJECTIVES

LO 3-1Ratio analysis provides a meaningful comparison of a company to its industry.

LO 3-2Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization.

LO 3-3The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders.

LO 3-4Trend analysis shows company performance over time.

LO 3-5Reported income must be further evaluated to identify sources of distortion.

If you’re in the market for dental products, look no further than Colgate-Palmolive. The firm has it all: every type of toothpaste you can imagine (tartar control, cavity protection, whitening enhancement), as well as every shape and size of toothbrush. While you’re getting ready for the day, also consider its soaps, shampoos, and deodorants (Tom’s of Maine, Speed Stick, Lady Speed Stick, etc.). If you decide to clean your apartment or dorm room, Colgate-Palmolive will provide you with Ajax, Palmolive dish soap, and a long list of other cleaning products.

All this is somewhat interesting, but why mention these subjects in a finance text? Well, Colgate-Palmolive has had some interesting profit numbers recently. Its profit margin in 2017 was 15 percent, and its return on assets was 19.4 percent. While these numbers are higher than those of the average company, the 2017 number that blows analysts away is its return on stockholders’ equity of over 900 percent (the norm is 15–20 percent). In fact, this ROE is so high and unrealistic that some financial services list the number as not meaningful (NMF). The major reason for this abnormally high return is its high debt-to-total-assets ratio of over 95 percent. This means that the firm’s debt represents more than 95 percent of total assets and stockholders’ equity less than 5 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity.

In contrast, its largest competitor, Procter & Gamble, has a different capital structure. Procter & Gamble is financed with 45.8 percent debt and 54.2 percent equity. Because of this more conservative capital structure, the company reports only a 17.8 percent return on stockholders’ equity. One capital structure is not necessarily better than the other, but this kind of financial analysis will be examined in this chapter.

In  Chapter 2 , we examined the basic assumptions of accounting and the various components that make up the financial statements of the firm. We now use this fundamental material as a springboard into financial analysis—to evaluate the financial performance of the firm.

The format for the chapter is twofold. In the first part, we use financial ratios to evaluate the relative success of the firm. Various measures such as net income to sales and current assets to current liabilities will be computed for a hypothetical company and examined in light of industry norms and past trends.

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

Ratio Analysis

Ratios are used in much of our daily life. We buy cars based on miles per gallon; we evaluate baseball players by earned run and batting averages, basketball players by field goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significance of the resultant number.

Financial ratios are used to weigh and evaluate the operating performance of the firm. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may appear satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio analysis.

For example, are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10 percent  “profit margin”  ratio), that might be quite satisfactory—whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this “number-crunching” process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, corporate governance, sustainability, and numerous other factors.

Many libraries and universities subscribe to financial services such as Bloomberg, Standard & Poor’s Industry Surveys and Corporate Reports, the Value Line Investment Survey FactSet, and Moody’s Corporation. Standard & Poor’s also leases a computer database called S&P IQ to banks, corporations, investment organizations, and universities. Compustat contains financial statement data on over 99,000 global securities for a 20-year period. Ratios can also be found on such websites as  finance.yahoo.com . These data can be used for countless ratios to measure corporate performance. The ratios used in this text are a sample of the major ratio categories used in business, but other classification systems can also be constructed.

Classification System

We will separate 13 significant ratios into four primary categories:

A. Profitability ratios

1. Profit margin

2. Return on assets (investment)

3. Return on equity

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B. Asset utilization ratios

2. Receivables turnover

2. Average collection period

2. Inventory turnover

2. Fixed asset turnover

2. Total asset turnover

1. Liquidity ratios

3. Current ratio

3. Quick ratio

1. Debt utilization ratios

4. Debt to total assets

4. Times interest earned

4. Fixed charge coverage

The first grouping, the  profitability ratios , allows us to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital. Many of the problems related to profitability can be explained, in whole or in part, by the firm’s ability to effectively employ its resources. Thus the next category is  asset utilization ratios . Under this heading, we measure the speed at which the firm is turning over accounts receivable, inventory, and longer-term assets. In other words, asset utilization ratios measure how many times per year a company sells its inventory or collects all of its accounts receivable. For long-term assets, the utilization ratio tells us how productive the fixed assets are in terms of generating sales.

In category C, the  liquidity ratios , the primary emphasis moves to the firm’s ability to pay off short-term obligations as they come due. In category D,  debt utilization ratios , the overall debt position of the firm is evaluated in light of its asset base and earning power.

The users of financial statements will attach different degrees of importance to the four categories of ratios. To the potential investor or security analyst, the critical consideration is profitability, with secondary consideration given to such matters as liquidity and debt utilization. For the banker or trade creditor, the emphasis shifts to the firm’s current ability to meet debt obligations. The bondholder, in turn, may be primarily influenced by debt to total assets—while also eyeing the profitability of the firm in terms of its ability to cover debt obligations. Of course, the experienced analyst looks at all the ratios, but with different degrees of attention.

Ratios are also important to people in the various functional areas of a business. The marketing manager, the head of production, the human resource manager, and many of their colleagues must all be familiar with ratio analysis. For example, the marketing manager must keep a close eye on inventory turnover; the production manager must evaluate the return on assets; and the human resource manager must look at the effect of “fringe benefits” expenditures on the return on sales.

The Analysis

Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Saxton Company, as presented in  Table 3-1 . The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

Table 3-1Financial statement for ratio analysis

SAXTON COMPANY Income Statement For the Year Ended December 31, 2018
Sales (all on credit)	$4,000,000
Cost of goods sold	3,000,000
Gross profit	$1,000,000
Selling and administrative expense *	450,000
Operating profit	$  550,000
Interest expense	50,000
Other income (expense), net	(225,000)
Net income before taxes	$  275,000
Taxes	75,000
Net income	$  200,000
* Includes $50,000 in lease payments.
Balance Sheet As of December 31, 2018
Assets
Cash	$     30,000
Marketable securities	50,000
Accounts receivable	350,000
Inventory	370,000
Total current assets	$    800,000
Net plant and equipment	800,000
Net assets	$1,600,000
Liabilities and Stockholders’ Equity
Accounts payable	$    50,000
Notes payable	250,000
Total current liabilities	$  300,000
Long-term liabilities	300,000
Total liabilities	$  600,000
Common stock	400,000
Retained earnings	600,000
Total liabilities and stockholders’ equity	$1,600,000

A. Profitability Ratios We first look at profitability ratios. The appropriate ratio is computed for the Saxton Company and is then compared to representative industry data.

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In analyzing the profitability ratios, we see the Saxton Company shows a lower return on the sales dollar (5 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 12.5 percent exceeds the industry norm of 10 percent. There is only one possible explanation for this occurrence—a more rapid turnover of assets than that generally found within the industry. This is verified in Ratio 2b, in which sales to total assets is 2.5 for the Saxton Company and only 1.5 for the industry. Thus Saxton earns less on each sales dollar, but it compensates by turning over its assets more rapidly (generating more sales per dollar of assets).

Return on total assets as described through the two components of profit margin and asset turnover is part of the  Du Pont system of analysis .

Return on assets (investment) = Profit margin × Asset turnover

The Du Pont company was a forerunner in stressing that satisfactory return on assets may be achieved through high profit margins or rapid turnover of assets, or a combination of both. We shall also soon observe that under the Du Pont system of analysis, the use of debt may be important. The Du Pont system causes the analyst to examine the sources of a company’s profitability. Since the profit margin is an income statement ratio, a high profit margin indicates good cost control, whereas a high asset turnover ratio demonstrates efficient use of the assets on the balance sheet. Different industries have different operating and financial structures. For example, in the heavy capital goods industry the emphasis is on a high profit margin with a low asset turnover—whereas in food processing, the profit margin is low and the key to satisfactory returns on total assets is a rapid turnover of assets.

Equally important to a firm is its return on equity or ownership capital. For the Saxton Company, return on equity is 20 percent, versus an industry norm of 15 percent. Thus the owners of Saxton Company are more amply rewarded than are other shareholders in the industry. This may be the result of one or two factors: a high return on total assets or a generous utilization of debt or a combination thereof. This can be seen through Ratio 3b, which represents a modified or second version of the Du Pont formula.

Note that the numerator, return on assets, is taken from Ratio 2b, which represents the initial version of the Du Pont formula (Return on assets = Net income/Sales × Sales/Total assets).  Return on assets  is then divided by [1 − (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Saxton Company, the modified version of the Du Pont formula shows

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Actually, the return on assets of 12.5 percent in the numerator is higher than the industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Please see the denominators in Ratio 3b to confirm these facts. Both the numerator and denominator contribute to a higher return on equity than the industry average (20 percent versus 15 percent). Note that if the firm had a 50 percent debt-to-assets ratio, return on equity would go up to 25 percent. 1

This does not necessarily mean debt is a positive influence, only that it can be used to boost return on equity. The ultimate goal for the firm is to achieve maximum valuation for its securities in the marketplace, and this goal may or may not be advanced by using debt to increase return on equity. Because debt represents increased risk, a lower valuation of higher earnings is possible. 2  Every situation must be evaluated individually.

You may wish to review  Figure 3-1 , which illustrates the key points in the Du Pont system of analysis.

Figure 3-1Du Pont analysis

As an example of the Du Pont analysis,  Table 3-2  compares two well-known retail store chains, Walmart and Target. In 2017, Target was more profitable in terms of profit margins (3.9 percent versus 2.8 percent). However, Walmart turned over its assets 2.4 times a year versus a slower 1.9 times for Target. Walmart’s long-held philosophy was set by its late founder, Sam Walton: Give the customer a bargain in terms of low prices (and low profit margins) but move the merchandise quickly (higher turnover).

Multiplying each company’s profit margin by the asset turnover, we see that Walmart and Target have similar returns on assets. However, notice that Walmart is more conservatively financed than Target. Walmart’s capital structure is 60.9 percent debt. Target uses 70.7 percent debt. As a result, Target’s return on equity was significantly higher. Keep in mind that a higher debt ratio also creates a more volatile ROE. While Target’s ROE was higher than Walmart’s, economic growth was high in 2017. If the economy falters, Target’s ROE will probably fall more than Walmart’s.

Finally, as a general statement in computing all the profitability ratios, the analyst must be sensitive to the age of the assets. Plant and equipment purchased 15 years ago may be carried on the books far below its replacement value in an inflationary economy. A 20 percent return on assets purchased in the early 1990s may be inferior to a 15 percent return on newly purchased assets.

B. Asset Utilization Ratios The second category of ratios relates to asset utilization, and the ratios in this category may explain why one firm can turn over its assets more rapidly than another. Notice that all of these ratios relate the balance sheet (assets) to the income statement (sales). The Saxton Company’s rapid turnover of assets is primarily explained in Ratios 4, 5, and 6.

Saxton collects its receivables faster than does the industry. This is shown by the  receivables turnover  of 11.4 times versus 10 times for the industry, and in daily terms by the average collection period of 32 days, which is 4 days faster than the industry norm. The  average collection period  suggests how long, on average, customers’ accounts stay on the books. The Saxton Company has $350,000 in accounts receivable and $4,000,000 in credit sales, which when divided by 360 days yields average daily credit sales of $11,111. We divide accounts receivable of $350,000 by average daily credit sales of $11,111 to determine how many days credit sales are on the books (32 days).

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Table 3-2Return on equity: Walmart vs. Target using the Du Pont method of analysis, 2017

In addition, the firm turns over its inventory 10.8 times per year, as contrasted with an industry average of 7 times. 3  This tells us that Saxton generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efficient inventory-ordering and cost-control methods.

The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry (5 versus 5.4), as shown above. This is a relatively minor consideration in view of the rapid movement of inventory and accounts receivable. Finally, the rapid turnover of total assets is again indicated (2.5 versus 1.5).

C. Liquidity Ratios After considering profitability and asset utilization, the analyst needs to examine the liquidity of the firm. The Saxton Company’s liquidity ratios fare well in comparison with the industry. Notice that Saxton’s  current ratio  is higher than the industry average because it has more current assets, relative to its current liabilities. This suggests that Saxton should be in a relatively good position to pay its current debts as they come due. Likewise, Saxton’s quick ratio is higher than its average competitor’s. Further analysis might involve building a cash budget to determine if the firm can meet each maturing obligation as it comes due.

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

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

Ratios for times interest earned and fixed charge coverage show that the Saxton Company debt is being well managed compared to the debt management of other firms in the industry. Times interest earned indicates the number of times that income before interest and taxes covers the interest obligation (11 times). The higher the ratio, the stronger is the interest-paying ability of the firm. The figure for income before interest and taxes ($550,000) in the ratio is the equivalent of the operating profit figure presented in the upper part of  Table 3-1 .

Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. In the present case, the Saxton Company has lease obligations of $50,000 as well as the $50,000 in interest expenses. Thus the total fixed charge financial obligation is $100,000. We also need to know the income before all fixed charge obligations. In this case, we take income before interest and taxes (operating profit) and add back the $50,000 in lease payments.

Income before interest and taxes	$550,000
Lease payments	50,000
Income before fixed charges and taxes	$600,000

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

Table 3-3Ratio analysis

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

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

Trend Analysis

Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one year may not present an accurate picture of the firm. Therefore, we look at the  trend analysis  of performance over a number of years. However, without industry comparisons even trend analysis may not present a complete picture.

For example, in Figure 3-2 we see that the profit margin for the Saxton Company has improved, while asset turnover has declined. This by itself may look good for the profit margin and bad for asset turnover. However, when compared to industry trends, we see the firm’s profit margin is still below the industry average. With asset turnover, Saxton has improved in relation to the industry, even though it is in a downward trend. Similar data could be generated for the other ratios.

By comparing companies in the same industry, the analyst can examine and compare trends over time. In looking at the computer industry data in Table 3-4, it is apparent that profit margins and returns on equity have changed over time for IBM and Apple. This is primarily due to intensified competition within the industry. IBM began to feel the squeeze on profits first, beginning in 1991, and actually lost money in 1993. By 1994, Lou Gerstner had taken over as chairman and chief executive officer at IBM and had begun turning the company around; by 1997, IBM was back to its old levels of profitability and hitting all-time highs for return on stockholders’ equity. This continued until the recession of 2001–2002. During the next decade, IBM engaged in financial engineering. It kept repurchasing shares of stock in the market, reducing its share count from 29.7 billion shares in 2004 to 17.2 billion shares in 2014. During the same years, its revenues decreased from $96.3 billion to $94.5 billion.

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Figure 3-2Trend analysis

In 2003, Apple Computer began its amazing 10-year run, creating the iPod, annual versions of the iPhone, the iPad, the iPad mini, and new versions of its MacBook and iMac computers. Note that even though Apple’s profit margin far exceeds that of IBM, IBM still has a higher return on equity. This takes us back to the Du Pont model. IBM has a debt-to-assets ratio of 84.5 percent in its capital structure, while Apple has a 64.3 percent debt-to-assets ratio.

Apple was almost debt free until 2013 when, under pressure from institutional stockholders, the company agreed to sell a total of $35.3 billion of debt and use the proceeds to buy back stock and raise its dividends. From 2015 to 2017, Apple spent almost $100 billion buying back stock and substantially increasing its debt-to-assets ratio. In contrasting the two companies, we should point out that while IBM’s revenues were stagnant from 2004 to 2017, Apple grew its revenues from $8.2 billion in 2004 to $229.234 billion, almost tripling IBM’s 2017 revenues of $78.4 billion.

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

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Table 3-4Trend analysis in the computer industry

Impact of Inflation on Financial Analysis

Before, coincident with, or following the computation of financial ratios, we should explore the impact of  inflation  and other sources of distortion on the financial reporting of the firm. As illustrated in this section, inflation causes phantom sources of profit that may mislead even the most alert analyst. Disinflation also causes certain problems, and we shall consider these as well.

The major problem during inflationary times is that revenue is almost always stated in current dollars, whereas plant and equipment or inventory may have been purchased at lower price levels. Thus profit may be more a function of increasing prices than of satisfactory performance. Although inflation has been moderate since the early 1990s, it tends to reappear, so you should be aware of its consequences.

Are Financial Analysts Friends or Foes to Investors? Reader Beware!

Finance in   ACTION Managerial

www.goldmansachs.com

www.ml.com

Financial analysis is done not only by managers of the firm but by outside analysts as well. These outside analysts normally supply data to stock market investors.

One of the problems that was detected after the great bull market of the 1990s was that analysts were not always as objective as they should have been. This unfortunate discovery helped intensify the bear market of the early 2000s.

The reason that many analysts lack objectivity is that they work for investment banking– brokerage firms that not only provide financial analysis for investors but also underwrite the securities of the firms they are covering. Underwriting activity involves the distribution of new securities in the public markets and is highly profitable to the investment banker. For example, Goldman Sachs, a major Wall Street investment banking firm, may not only be doing research and financial analysis on General Electric or Eastman Kodak but also profiting from investment banking business with these firms.

Since the fees from investment banking activities contribute heavily to the overall operations of the investment banker, many analysts for investment banking firms “relaxed their standards” in doing financial analysis on their clients in the 1990s.

As an example, Goldman Sachs, Merrill Lynch, and other Wall Street firms often failed to divulge potential weaknesses in the firms they were investigating for fear of losing the clients’ investment banking business. Corporations that were being reported upon were equally guilty. Many a corporate chief officer told an investment banker that “if you come out with a negative report, you will never see another dollar’s worth of our investment banking business.” Morgan Stanley, a major investment banker, actually had a written internal policy for analysts never to make negative comments about firms providing investment banking fees. Pity the poor investor who naively followed the advice of Morgan Stanley during the mid-1990s.

After the market crash of the early 2000s, the SEC and federal legislators began requiring investment bankers to either fully separate their financial analysis and underwriting business or, at a minimum, fully divulge any such relationships. For example, Merrill Lynch now states in its research reports, “Investors should assume that Merrill Lynch is seeking or will seek investing banking or other business relationships with the companies in this report.”

The government is also requiring investment bankers to provide independent reports to accompany their own in-house reports. These independent reports are done by fee-based research firms that do not engage in underwriting activities. Independent firms include Standard & Poor’s, Value Line, Morningstar, and other smaller firms. They tend to be totally objective and hard-hitting when necessary.

Some independent research firms know more about a company than it knows about itself. Take the example of Sanford C. Bernstein & Co. and Cisco Systems in late 2000. Bernstein analyst Paul Sagawa downgraded Cisco for investment purposes, even though Cisco Chief Executive Officer John T. Chambers respectfully disagreed. The astute independent analyst anticipated the end of the telecom boom and knew the disastrous effect it would have on Cisco because the company would lose key telecom customers. When the disaster finally occurred, CEO Chambers told investors that “no one could have predicted it. It was like a 100-year flood.” Apparently, he forgot about the Sagawa report he had read and dismissed only a few months before.

An Illustration

The Stein Corporation shows the income statement for 2018 in Table 3-5. At year-end the firm also has 100 units still in inventory at $1 per unit.

Assume that in the year 2019 the number of units sold remains constant at 100. However, inflation causes a 10 percent increase in price, from $2 to $2.20. Total sales will go up to $220, as shown in Table 3-6, but with no actual increase in physical volume. Further, assume the firm uses FIFO inventory pricing, so that inventory first purchased will be written off against current sales. In this case, 2018 inventory will be written off against year 2019 sales revenue.

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Table 3-5Stein Corporation income statement for 2018

STEIN CORPORATION Net Income for 2018
Sales	$ 200	(100 units at $2)
Cost of goods sold	100	(100 units at $1)
Gross profit	$ 100
Selling and administrative expense	20	(10% of sales)
Depreciation	10
Operating profit	$  70
Taxes (24%)	17
Aftertax income	$  53

Table 3-6Stein Corporation income statement for 2019

STEIN CORPORATION Net Income for 2019
Sales	$220	(100 units at 2000 price of $2.20)
Cost of goods sold	100	(100 units at $1.00)
Gross profit	$120
Selling and administrative expense	22	(10% of sales)
Depreciation	10
Operating profit	$  88
Taxes (24%)	21
Aftertax income	$  67

In Table 3-6, the company appears to have increased profit by $14 compared to that shown in Table 3-5 (from $53 to $67) simply as a result of inflation. But not reflected is the increased cost of replacing inventory and plant and equipment. Presumably,  replacement costs  have increased in an inflationary environment.

As mentioned in Chapter 2, inflation-related information was formerly required by the FASB for large companies, but this is no longer the case. It is now purely voluntary. What are the implications of this type of inflation-adjusted data? From a study of 10 chemical firms and 8 drug companies, using current cost (replacement cost) data found in the financial 10K statements these companies filed with the Securities and Exchange Commission, it was found that the changes shown in Table 3-7 occurred in their assets, income, and selected ratios.5

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

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

Disinflation Effect

As long as prices continue to rise in an inflationary environment, profits appear to feed on themselves. The main problem is that when price increases moderate (  disinflation ), there will be a rude awakening for management and unsuspecting stockholders as expensive inventory is charged against softening retail prices. A 15 or 20 percent growth rate in earnings may be little more than an “inflationary illusion.” Industries most sensitive to inflation-induced profits are those with cyclical products, such as lumber, copper, rubber, and food products, as well as those in which inventory is a significant percentage of sales and profits.

A leveling off of prices is not necessarily bad. Even though inflation-induced corporate profits may be going down, investors may be more willing to place their funds in financial assets such as stocks and bonds. The reason for the shift may be a belief that declining inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lessening inflation means the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current valuation.

None of this happens with a high degree of certainty. To the extent that investors question the permanence of disinflation (leveling off of price increases), they may not act according to the script. That is, lower rates of inflation will not necessarily produce high stock and bond prices unless reduced inflation is sustainable over a reasonable period.

Whereas financial assets such as stocks and bonds have the potential (whether realized or not) to do well during disinflation, such is not the case for tangible (real) assets. Precious metals, such as gold and silver, gems, and collectibles, which boomed in the highly inflationary environment of the late 1970s, fell off sharply a decade later, as softening prices reduced the perceived need to hold real assets as a hedge against inflation. The shifting back and forth by investors between financial and real assets may occur many times over a business cycle.

Deflation  There is also the danger of deflation, actual declining prices in which everyone gets hurt from bankruptcies and declining profits. Deflation was a major contributor to the length and severity of the worldwide Great Depression of the 1930s. Deflation occurred again in Russia, Japan, and other foreign countries in 1998, and it became a concern in the United States during the “Great Recession” from 2007 to 2012. The Federal Reserve and other national banks would rather have a low- inflation economy (1 or 2 percent per year) than a deflationary economy.

Other Elements of Distortion in Reported Income

The effect of changing prices is but one of a number of problems the analyst must cope with in evaluating a company. Other issues, such as the reporting of revenue, the treatment of nonrecurring items, and the tax write-off policy, cause dilemmas for the financial manager or analyst. We can illustrate this point by considering the income statements for two hypothetical companies in the same industry, as shown in Table 3-8. Both firms had identical operating performances for 2018—but Company A is very conservative in reporting its results, while Company B has attempted to maximize its reported income.

If both companies had reported income of $280,000 in the prior year of 2017, Company B would be thought to be showing substantial growth in 2018 with net income of $700,000, while Company A would be reporting a “flat,” or no-growth, year in 2018. However, we have already established that the companies have equal operating performances.

Explanation of Discrepancies

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

Sales Company B reported $200,000 more in sales, although actual volume was the same. This may be the result of different concepts of revenue recognition.

For example, certain assets may be sold on an installment basis over a long period. A conservative firm may defer recognition of the sales or revenue until each payment is received, while other firms may attempt to recognize a fully effected sale at the earliest possible date. Similarly, firms that lease assets may attempt to consider a long-term lease as the equivalent of a sale, while more conservative firms recognize as revenue each lease payment only when it comes due. Although the accounting profession attempts to establish appropriate methods of financial reporting through generally accepted accounting principles, reporting varies among firms and industries.

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Table 3-8Income Statements

INCOME STATEMENTS For the Year 2018
		High Reported
	Conservative	Income
	Firm A	Firm B
Sales	$4,000,000	$4,200,000
Cost of goods sold	3,000,000	2,700,000
Gross profit	$1,000,000	$1,500,000
Selling and administrative expense	450,000	450,000
Operating profit	$  550,000	$1,050,000
Interest expense	50,000	50,000
Net income before taxes	$  500,000	$1,000,000
Taxes (30%)	150,000	300,000
Net income transferred to retained earnings	$  350,000	$  700,000

page 75 

Sustainability, ROA, and the “Golden Rule”

Finance in  ACTION Ethics

Perhaps “sustainability” isn’t the first word that comes to mind when someone thinks about the garbage business. However, today’s waste industry leaders not only develop sanitary landfills with synthetic liners and ground water monitoring wells but are often at the forefront of community recycling and renewable energy efforts.

When Lonnie Poole started Waste Industries in 1970, he didn’t know that the company would grow to be one of the country’s largest waste companies, but like most entrepreneurs, he did believe that he could build a business for the long haul. Focused on a commitment to service, Poole knew that his company had to find ways to offer service options that were both economically viable and environmentally sustainable. Sometimes projects provided an adequate near-term return on assets (ROA) and they made sense from a sustainability perspective. Other times, doing the right thing from a long-term sustainability perspective meant Waste Industries needed to find a way to overcome short-term financial considerations.

Take the company’s recycling effort as an example. Waste Industries has been engaged in recycling since the 1970s. From an ROA perspective, it was hard to justify the firm’s recycling efforts. At first, there was no market for the recyclables. Instead of selling recycled paper, the firm had to pay paper companies to haul recycled paper away. Over time, Waste Industries’ investments in sustainability began to pay off. Due to its early investments, today an infrastructure has developed to recycle more waste at lower costs.

Based purely on a short-run ROA, the firm’s long-term commitment was not justified, but Poole’s commitment to recycling and other sustainable practices were part of a wider corporate culture focused on treating customers, employees, and the broader community with respect.

Now business researchers are finding that Poole may have simply been ahead of his time. When Harvard researchers examined the impact of corporate sustainability initiatives on long-term firm performance, they discovered both higher ROA and higher ROE (return on equity) for firms whose executives promoted sustainability within their firms.

Philosophers and religious leaders have long touted the “Golden Rule” as a basic ethical code, which states people should do to others what they would wish done to themselves. Like many successful businesspeople, Poole believed sustainability meant making a positive difference in the communities his company served, enriching the lives of employees, and forging meaningful relationships with vendors and suppliers. In the long run, these values paid off. Perhaps this is why a basic rule for ethical behavior is called “golden.”

Source: Eccles, R.G., Ioannou, I., and Serafelm, G. “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance,” NBER Working Paper No. 17950, 2012.

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

Net Income

Firm A has reported net income of $350,000, while Firm B claims $700,000. The $350,000 difference is attributed to different methods of financial reporting, and it should be recognized as such by the analyst. No superior performance has actually taken place. The analyst must remain ever alert in examining each item in the financial statements, rather than accepting bottom-line figures.

SUMMARY

Ratio analysis allows the analyst to compare a company’s performance to that of others in its industry. Ratios that initially appear good or bad may not retain that characteristic when measured against industry peers.

There are four main groupings of ratios. Profitability ratios measure the firm’s ability to earn an adequate return on sales, assets, and stockholders’ equity. The asset utilization ratios tell the analyst how quickly the firm is turning over its accounts receivable, inventory, and longer-term assets. Liquidity ratios measure the firm’s ability to pay off short-term obligations as they come due, and debt utilization ratios indicate the overall debt position of the firm in light of its asset base and earning power.

The Du Pont system of analysis first breaks down return on assets between the profit margin and asset turnover. The second step shows how this return on assets is translated into return on equity through the amount of debt the firm has. Throughout the analysis, the analyst can better understand how return on assets and return on equity are derived.

Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one year may not present an accurate picture of the firm. Therefore, we look at the trend analysis of performance over a period of years.

A number of factors may distort the numbers accountants actually report. These include the effect of inflation or disinflation, the timing of the recognition of sales as revenue, the treatment of inventory write-offs, and so on. The well-trained financial analyst must be alert to all of these factors.

LIST OF TERMS

profitability ratios     59

profit margin

return on assets

return on equity

asset utilization ratios     60

receivables turnover

average collection period

inventory turnover

fixed asset turnover

total asset turnover

liquidity ratios     60

current ratio

quick ratio

debt utilization ratios     60

debt to total assets

times interest earned

fixed charge coverage

Du Pont system of analysis     62

trend analysis     67

inflation     69

replacement costs     71

disinflation     72

deflation     72

LIFO     74

FIFO     74

DISCUSSION QUESTIONS

1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, which ratios would each group be most interested in, and for what reasons? ( LO3-2 )

page 77

2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. ( LO3-3 )

3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period? ( LO3-2 )

4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned? ( LO3-2 )

5. Is there any validity in rule-of-thumb ratios for all corporations, such as a current ratio of 2 to 1 or debt to assets of 50 percent? ( LO3-2 )

6. Why is trend analysis helpful in analyzing ratios? ( LO3-4 )

7. Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions. ( LO3-5 )

a. Return on investment

b. Inventory turnover

c. Fixed asset turnover

d. Debt-to-assets ratio

8. What effect will disinflation following a highly inflationary period have on the reported income of the firm? ( LO3-5 )

9. Why might disinflation prove favorable to financial assets? ( LO3-5 )

10. Comparisons of income can be very difficult for two companies, even though they sell the same products in equal volume. Why? ( LO3-2 )

PRACTICE PROBLEMS AND SOLUTIONS

Profitability ratios ( LO3-2 )

1. Barnes Appliances has sales of $10,000,000, net income of $450,000, total assets of $4,000,000, and stockholders’ equity of $2,000,000.

a. What is the profit margin?

b. What is the return on assets?

c. What is the return on equity?

d. The debt-to-assets ratio is currently 50 percent. If it were 60 percent, what would the return on equity be? To answer this question, use Ratio 3b in the text.

Profitability ratios ( LO3-2 )

2. The Gilliam Corp. has the following balance sheet and income statement. Compute the profitability, asset utilization, liquidity, and debt utilization ratios.

GILLIAM CORPORATION Balance Sheet December 31, 20X1
Assets
Current assets:
Cash	$    70,000
Marketable securities	40,000
Accounts receivable (net)	250,000
Inventory	200,000
Total current assets	$  560,000
Investments	100,000
Net plant and equipment	440,000
Total assets	$ 1,100,000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$    130,000
Notes payable	120,000
Accrued taxes	30,000
Total current liabilities	$    280,000
Long-term liabilities:
Bonds payable	$    200,000
Total liabilities	$    480,000
Stockholders’ equity
Preferred stock, $100 par value	$    150,000
Common stock, $5 par value	50,000
Capital paid in excess of par	200,000
Retained earnings	220,000
Total stockholders’ equity	$    620,000
Total liabilities and stockholders’ equity	$ 1,100,000

3.

GILLIAM CORPORATION Income Statement For the Year Ending December 31, 20X1
Sales (on credit)	$ 2,400,000
Less: Cost of goods sold	1,600,000
Gross profit	$   800,000
Less: Selling and administrative expenses	560,000*
Operating profit (EBIT)	$   240,000
Less: Interest expense	30,000
Earnings before taxes (EBT)	$   210,000
Less: Taxes	75,000
Earnings after taxes (EAT)	$   135,000

4. *Includes $40,000 in lease payments.

Solutions

1.

a.

b.

c.

page 78

d.

2. Profitability ratios

2.

2.

2.

Asset utilization ratios

4.

5.

6.

7.

8.

Liquidity ratios

9.

10.

Debt utilization ratios

11.

12.

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

Times interest earned 

11.

Income before fixed charges and taxes = Operating profit + Lease payments*

$240,000 + $40,000 = $280,000

Fixed charges = Lease payments = Interest

$40,000 + $30,000 = $70,000

Fixed charge coverage 

PROBLEMS

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

Basic Problems

Profitability ratios ( LO3-2 )

1. Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of $156,000 on sales of $2,010,000. Division B is able to make only $28,800 on sales of $329,000. Based on the profit margins (returns on sales), which division is superior?

Profitability ratios ( LO3-2 )

2. Database Systems is considering expansion into a new product line. Assets to support expansion will cost $380,000. It is estimated that Database can generate $1,410,000 in annual sales, with an 8 percent profit margin. What would net income and return on assets (investment) be for the year?

Profitability ratios ( LO3-2 )

3. Polly Esther Dress Shops Inc. can open a new store that will do an annual sales volume of $837,900. It will turn over its assets 1.9 times per year. The profit margin on sales will be 8 percent. What would net income and return on assets (investment) be for the year?

Profitability ratios ( LO3-2 )

4. Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns over its assets 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit margin (return on sales)?

Profitability ratios ( LO3-2 )

5. Elizabeth Tailors Inc. has assets of $8,940,000 and turns over its assets 1.9 times per year. Return on assets is 13.5 percent. What is the firm’s profit margin (returns on sales)?

Profitability ratios ( LO3-2 )

6. Dr. Zhivàgo Diagnostics Corp.’s income statement for 20X1 is as follows:

Sales	$ 2,790,000
Cost of goods sold	1,790,000
Gross profit	$ 1,000,000
Selling and administrative expense	302,000
Operating profit	$    698,000
Interest expense	54,800
Income before taxes	$    643,200
Taxes (30%)	192,960
Income after taxes	$    450,240

a. Compute the profit margin for 20X1.

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

page 80

Profitability ratios ( LO3-2 )

7. The Haines Corp. shows the following financial data for 20X1 and 20X2:

	20X1	20X2
Sales	$ 3,230,000	$ 3,370,000
Cost of goods sold	2,130,000	2,850,000
Gross profit	$ 1,100,000	$    520,000
Selling & administrative expense	298,000	227,000
Operating profit	$    802,000	$    293,000
Interest expense	47,200	51,600
Income before taxes	$    754,800	$    241,400
Taxes (35%)	264,180	84,490
Income after taxes	$    490,620	$    156,910

8. For each year, compute the following and indicate whether it is increasing or decreasing profitability in 20X2 as indicated by the ratio:

a. Cost of goods sold to sales.

b. Selling and administrative expense to sales.

c. Interest expenses to sales.

Profitability ratios ( LO3-2 )

8. Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of debt. It reports net income of $200,000.

a. What is the firm’s return on assets?

b. What is its return on stockholders’ equity?

c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin (return on sales)?

Profitability ratios ( LO3-2 )

9. Network Communications has total assets of $1,500,000 and current assets of $612,000. It turns over its fixed assets three times a year. It has $319,000 of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity?

Profitability ratios ( LO3-2 )

10. Fondren Machine Tools has total assets of $3,310,000 and current assets of $879,000. It turns over its fixed assets 3.6 times per year. Its return on sales is 4.8 percent. It has $1,750,000 of debt. What is its return on stockholders’ equity?

Profitability ratios ( LO3-2 )

11. Baker Oats had an asset turnover of 1.6 times per year.

a. If the return on total assets (investment) was 11.2 percent, what was Baker’s profit margin?

b. The following year, on the same level of assets, Baker’s asset turnover declined to 1.4 times and its profit margin was 8 percent. How did the return on total assets change from that of the previous year?

Du Pont system of analysis ( LO3-3 )

12. AllState Trucking Co. has the following ratios compared to its industry for last year:

	AllState Trucking	Industry
Return on sales	3%	8%
Return on assets	15%	10%

13. page 81 

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

Du Pont system of analysis ( LO3-3 )

13. Front Beam Lighting Company has the following ratios compared to its industry for last year:

	Front Beam Lighting	Industry
Return on assets	12%	5%
Return on equity	16%	20%

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

Du Pont system of analysis ( LO3-3 )

14. Gates Appliances has a return-on-assets (investment) ratio of 8 percent.

a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity?

b. If the firm had no debt, what would the return-on-equity ratio be?

Intermediate Problems

Du Pont system of analysis ( LO3-3 )

15. Using the Du Pont method, evaluate the effects of the following relationships for the Butters Corporation:

a. Butters Corporation has a profit margin of 7 percent and its return on assets (investment) is 25.2 percent. What is its assets turnover?

b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm’s return on equity be?

c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35 percent?

Du Pont system of analysis ( LO3-3 )

16. Jerry Rice and Grain Stores has $4,780,000 in yearly sales. The firm earns 4.5 percent on each dollar of sales and turns over its assets 2.7 times per year. It has $123,000 in current liabilities and $349,000 in long-term liabilities.

a. What is its return on stockholders’ equity?

b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same, as do current and long-term liabilities.

Interpreting results from the Du Pont system of analysis ( LO3-3 )

17. Assume the following data for Cable Corporation and Multi-Media Inc.:

	Cable Corporation	Multi-Media Inc.
Net income	$    31,200	$   140,000
Sales	317,000	2,700,000
Total assets	402,000	965,000
Total debt	163,000	542,000
Stockholders’ equity	239,000	423,000

17.

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

b. Compute the following additional ratios for both firms:

Net income/Sales

Net income/Total assets

Sales/Total assets

Debt/Total assets

c. Discuss the factors from part b that added or detracted from one firm having a higher return on stockholders’ equity than the other firm, as computed in part a.

Average collection period ( LO3-2 )

18. A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is $285,000. What is the average collection period? (Use a 360-day year.)

Average daily sales ( LO3-2 )

19. Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales?

Inventory turnover ( LO3-2 )

20. Perez Corporation has the following financial data for the years 20X1 and 20X2:

	20X1	20X2
Sales	$ 8,000,000	$ 10,000,000
Cost of goods sold	6,000,000	9,000,000
Inventory	800,000	1,000,000

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

b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year.

c. What conclusions can you draw from part a and part b?

Turnover ratios ( LO3-2 )

21. Jim Short’s Company makes clothing for schools. Sales in 20X1 were $4,820,000. Assets were as follows:

Cash	$    163,000
Accounts receivable	889,000
Inventory	411,000
Net plant and equipment	520,000
Total assets	$ 1,983,000

a. Compute the following:

1. Accounts receivable turnover

2. Inventory turnover

3. Fixed asset turnover

4. Total asset turnover

page 83 

b. In 20X2, sales increased to $5,740,000 and the assets for that year were as follows:

Cash	$     163,000
Accounts receivable	924,000
Inventory	1,063,000
Net plant and equipment	520,000
Total assets	$ 2,670,000

c. Once again, compute the four ratios.

d. Indicate if there is an improvement or a decline in total asset turnover, and based on the other ratios, indicate why this development has taken place.

Overall ratio analysis ( LO3-2 )

22. The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000, with 90 percent of sales sold on credit.

STUD CLOTHIERS Balance Sheet 20X1
Assets	Liabilities and Equity
Cash	$     60,000	Accounts payable	$    220,000
Accounts receivable	240,000	Accrued taxes	30,000
Inventory	350,000	Bonds payable (long-term)	150,000
Plant and equipment	410,000	Common stock	80,000
		Paid-in capital	200,000
		Retained earnings	380,000
Total assets	$ 1,060,000	Total liabilities and equity	$ 1,060,000

23. Compute the following ratios:

a. Current ratio

b. Quick ratio

c. Debt-to-total-assets ratio

d. Asset turnover

e. Average collection period

Debt utilization ratios ( LO3-2 )

23. The Lancaster Corporation’s income statement is given below.

a. What is the times-interest-earned ratio?

b. What would be the fixed-charge-coverage ratio?

LANCASTER CORPORATION
Sales	$ 246,000
Cost of goods sold	122,000
Gross profit	$ 124,000
Fixed charges (other than interest)	27,500
Income before interest and taxes	$   96,500
Interest	21,800
Income before taxes	$   74,700
Taxes (35%)	26,145
Income after taxes	$   48,555

page 84 

Debt utilization and Du Pont system of analysis ( LO3-3 )

24. Using the income statement for Times Mirror and Glass Co., compute the following ratios:

a. The interest coverage

b. The fixed charge coverage

The total assets for this company equal $80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e.

24. Profit margin

24. Total asset turnover

24. Return on assets (investment)

TIMES MIRROR AND GLASS COMPANY
Sales	$ 126,000
Less: Cost of goods sold	93,000
Gross profit	$  33,000
Less: Selling and administrative expense	11,000
Less: Lease expense	4,000
Operating profit*	$  18,000
Less: Interest expense	3,000
Earnings before taxes	$  15,000
Less: Taxes (30%)	4,500
Earnings after taxes	$  10,500

24. *Equals income before interest and taxes.

Debt utilization ( LO3-2 )

25. A firm has net income before interest and taxes of $193,000 and interest expense of $28,100.

a. What is the times-interest-earned ratio?

b. If the firm’s lease payments are $48,500, what is the fixed charge coverage?

Advanced Problems

Return on assets analysis ( LO3-2 )

26. In January 2007, the Status Quo Company was formed. Total assets were $544,000, of which $306,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation of $30,600 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $29,000 per year each of the last 10 years. Other assets have not changed since 2007.

a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016. (Use $29,000 in the numerator for each year.)

b. To what do you attribute the phenomenon shown in part a?

c. Now assume income increased by 10 percent each year. What effect would this have on your preceding answers? (A comment is all that is necessary.)

Trend analysis ( LO3-4 )

27. Jolie Foster Care Homes Inc. shows the following data:

a. Compute the ratio of net income to total assets for each year, and comment on the trend.

b. Compute the ratio of net income to stockholders’ equity, and comment on the trend. Explain why there may be a difference in the trends between parts aand b.

Trend analysis ( LO3-4 )

28. Quantum Moving Company has the following data. Industry information also is shown.

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

29. As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of the following?

a. Net income/Total assets

b. Debt/Total assets

Analysis by divisions ( LO3-2 )

29. The Global Products Corporation has three subsidiaries.

	Medical Supplies	Heavy Machinery	Electronics
Sales	$20,040,000	$5,980,000	$4,730,000
Net income (after taxes)	1,700,000	592,000	402,000
Assets	8,340,000	8,760,000	3,570,000

a. Which division has the lowest return on sales?

b. Which division has the highest return on assets?

c. Compute the return on assets for the entire corporation.

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

page 86 

Analysis by affiliates ( LO3-1 )

30. Omni Technology Holding Company has the following three affiliates:

	Software	Personal Computers	Foreign Operations
Sales	$40,200,000	$60,080,000	$100,680,000
Net income (after taxes)	2,086,000	2,880,000	8,510,000
Assets	5,820,000	25,790,000	60,630,000
Stockholders’ equity	4,090,000	10,170,000	50,950,000

a. Which affiliate has the highest return on sales?

b. Which affiliate has the lowest return on assets?

c. Which affiliate has the highest total asset turnover?

d. Which affiliate has the highest return on stockholders’ equity?

e. Which affiliate has the highest debt ratio? (Assets minus stockholders’ equity equals debt.)

f. Returning to part b, explain why the software affiliate has the highest return on total assets.

g. Returning to part d, explain why the personal computer affiliate has a higher return on stockholders’ equity than the foreign operations affiliate, even though it has a lower return on total assets.

Inflation and inventory accounting effect ( LO3-5 )

31. The Canton Corporation shows the following income statement. The firm uses FIFO inventory accounting.

CANTON CORPORATION Income Statement for 20X1
Sales	$272,800	(17,600 units at $15.50)
Cost of goods sold	123,200	(17,600 units at $7.00)
Gross profit	$149,600
Selling and administrative expense	13,640
Depreciation	15,900
Operating profit	$120,060
Taxes (30%)	36,018
Aftertax income	$  84,042

a. Assume in 20X2 the same 17,600-unit volume is maintained but that the sales price increases by 10 percent. Because of FIFO inventory policy, old inventory will still be charged off at $7 per unit. Also assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute aftertax income for 20X2.

b. In part a, by what percentage did aftertax income increase as a result of a 10 percent increase in the sales price? Explain why this impact took place.

c. Now assume that in 20X3 the volume remains constant at 17,600 units, but the sales price decreases by 15 percent from its year 20X2 level. Also, because of FIFO inventory policy, cost of goods sold reflects the inflationary conditions of the prior year and is $7.50 per unit. Further, assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute the aftertax income.

page 87 

Using ratios to construct financial statements ( LO3-2 )

32. Construct the current assets section of the balance sheet from the following data. (Use cash as a plug figure after computing the other values.)

Yearly sales (credit)	$420,000
Inventory turnover	7 times
Current liabilities	$80,000
Current ratio	2
Average collection period	36 days
Current assets:	$
Cash	__________
Accounts receivable	__________
Inventory	__________
Total current assets	__________

Using ratios to construct financial statements ( LO3-2 )

33. The Griggs Corporation has credit sales of $1,200,000. Given these ratios, fill in the following balance sheet.

Total assets turnover	2.4 times
Cash to total assets	2.0%
Accounts receivable turnover	8.0 times
Inventory turnover	10.0 times
Current ratio	2.0 times
Debt to total assets	61.0%

34.

GRIGGS CORPORATION Balance Sheet
Assets	Liabilities and Stockholders’ Equity
Cash	________	Current debt	________
Accounts receivable	________	Long-term debt	________
Inventory	________	Total debt	________
Total current assets	________	Equity	________
Fixed assets	________	Total debt and stockholders’ equity	________
Total assets	________

Using ratios to determine account balances ( LO3-2 )

34. We are given the following information for the Pettit Corporation:

Sales (credit)	$3,549,000
Cash	179,000
Inventory	911,000
Current liabilities	788,000
Asset turnover	1.40 times
Current ratio	2.95 times
Debt-to-assets ratio	40%
Receivables turnover	7 times

35. Current assets are composed of cash, marketable securities, accounts receivable, and inventory. Calculate the following balance sheet items:

a. Accounts receivable

b. Marketable securities

34.

a. page 88

b. Fixed assets

c. Long-term debt

Using ratios to construct financial statements ( LO3-2 )

35. The following information is from Harrelson Inc.’s financial statements. Sales (all credit) were $28.50 million for last year.

Sales to total assets	1.90 times
Total debt to total assets	35%
Current ratio	2.50 times
Inventory turnover	10.00 times
Average collection period	20 days
Fixed asset turnover	5.00 times

36. Fill in the balance sheet:

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

Comparing all the ratios ( LO3-2 )

36. Using the financial statements for the Snider Corporation, calculate the 13 basic ratios found in the chapter.

SNIDER CORPORATION Balance Sheet December 31, 20X1
Assets
Current assets:
Cash	$ 52,200
Marketable securities	24,400
Accounts receivable (net)	222,000
Inventory	238,000
Total current assets	$536,600
Investments	65,900
Plant and equipment	$615,000
Less: Accumulated depreciation	(271,000)
Net plant and equipment	$344,000
Total assets	$946,500
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$ 93,400
Notes payable	70,600
Accrued taxes	17,000
Total current liabilities	$181,000
Long-term liabilities:
Bonds payable	$153,200
Total liabilities	$334,200
Stockholders’ equity:
Preferred stock, $50 per value	$100,000
Common stock, $1 par value	80,000
Capital paid in excess of par	190,000
Retained earnings	242,300
Total stockholders’ equity	$612,300
Total liabilities and stockholders’ equity	$946,500

37. page 89 

SNIDER CORPORATION Income statement For the Year Ending December 31, 20X1
Sales (on credit)	$2,064,000
Less: Cost of goods sold	1,313,000
Gross profit	$  751,000
Less: Selling and administrative expenses	496,000 *
Operating profit (EBIT)	$  255,000
Less: Interest expense	26,900
Earnings before taxes (EBT)	$  228,100
Less: Taxes	83,300
Earnings after taxes (EAT)	$ 144,800

38. * Includes $36,100 in lease payments.

Ratio computation and analysis ( LO3-2 )

37. Given the financial statements for Jones Corporation and Smith Corporation shown here,

a. To which one would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering.

b. In which one would you buy stock? Why?

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

37.

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

38. *Use net fixed assets in computing fixed asset turnover.

39. †Includes $7,000 in lease payments.

SMITH CORPORATION
Current Assets	Liabilities
Cash	$  35,000	Accounts payable	$  75,000
Marketable securities	7,500	Bonds payable (long-term)	210,000
Accounts receivable	70,000
Inventory	75,000
Long-Term Assets	Stockholders’ Equity
Fixed assets	$500,000	Common stock	$ 75,000
Less: Accum. dep.	(250,000)	Paid-in capital	30,000
Net fixed assets*	250,000	Retained earnings	47,500
Total assets	$437,500	Total liab. and equity	$437,500

40. *Use net fixed assets in computing fixed asset turnover.

SMITH CORPORATION
	Sales (on credit)	$1,000,000
	Cost of goods sold	600,000
	Gross profit	$   400,000
	Selling and administrative expense†	224,000
	Depreciation expense	50,000
	Operating profit	$   126,000
	Interest expense	21,000
	Earnings before taxes	$   105,000
	Tax expense	52,500
	Net income	$     52,500

†Includes $7,000 in lease payments.

COMPREHENSIVE PROBLEM

Lamar Swimwear

(Trend analysis and industry comparisons) ( LO3-4 )

Bob Adkins has recently been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products.

Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years, as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year.

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There was a steady real growth of 3 to 4 percent in gross domestic product during the period under study.

Exhibit 1

LAMAR SWIMWEAR Income Sheet
	20X1	20X2	20X3
Sales (all on credit)	$1,200,000	$1,500,000	$1,875,000
Cost of goods sold	800,000	1,040,000	1,310,000
Gross profit	$   400,000	$   460,000	$   565,000
Selling and administrative expense*	239,900	274,000	304,700
Operating profit (EBIT)	$   160,100	$   186,000	$   260,300
Interest expense	35,000	45,000	85,000
Net income before taxes	$   125,100	$   141,000	$   175,300
Taxes	36,900	49,200	55,600
Net income	$    88,200	$    91,800	$   119,700
Shares	30,000	30,000	38,000
Earnings per share	$2.94	$3.06	$3.15

*Includes $15,000 in lease payments for each year.

Exhibit 2

LAMAR SWIMWEAR Balance Sheet
Assets	20X1	20X2	20X3
Cash	$     30,000	$     40,000	$     30,000
Marketable securities	20,000	25,000	30,000
Accounts receivable	170,000	259,000	360,000
Inventory	230,000	261,000	290,000
Total current assets	$   450,000	$   585,000	$   710,000
Net plant and equipment	650,000	765,000	1,390,000
Total assets	$1,100,000	$1,350,000	$2,100,000
Liabilities and Stockholders’ Equity
Accounts payable	$   200,000	$   310,000	$   505,000
Accrued expenses	20,400	30,000	35,000
Total current liabilities	$   220,400	$   340,000	$   540,000
Long-term liabilities	325,000	363,600	703,900
Total liabilities	$   545,400	$   703,600	$1,243,900
Common stock ($2 par)	60,000	60,000	76,000
Capital paid in excess of par	190,000	190,000	264,000
Retained earnings	304,600	396,400	516,100
Total stockholders’ equity	$   554,600	$   646,400	$   856,100
Total liabilities and stockholders’ equity	$1,100,000	$1,350,000	$2,100,000

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Exhibit 3

Selected Industry Ratios
	20X1	20X2	20X3
Growth in sales	—	10.00%	12.00%
Profit margin	7.71%	7.82%	7.96%
Return on assets (investment)	7.94%	8.86%	8.95%
Return on equity	14.31%	15.26%	16.01%
Receivables turnover	9.02X	8.86X	9.31X
Average collection period	39.9 days	40.6 days	38.7 days
Inventory turnover	4.24X	5.10X	5.11X
Fixed asset turnover	1.60X	1.64X	1.75X
Total asset turnover	1.05X	1.10X	1.12X
Current ratio	1.96X	2.25X	2.40X
Quick ratio	1.37X	1.41X	1.38X
Debt to total assets	43.47%	43.11%	44.10%
Times interest earned	6.50X	5.99X	6.61X
Fixed charge coverage	4.70X	4.69X	4.73X
Growth in EPS	—	10.10%	13.30%

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

COMPREHENSIVE PROBLEM

Sun Microsystems

(Trends, ratios, stock performance) ( LO3-1 ,  LO3-2 ,  LO3-3 ,  LO3-4 )

Sun Microsystems is a leading supplier of computer-related products, including servers, workstations, storage devices, and network switches. In 2009, Sun Microsystems was acquired by Oracle Corporation.

In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G. McNealy offered the following remarks:

Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still, we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good indication that Sun continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively brought costs down—even as they continued to bring exciting new products to market.

The statement would not appear to be telling you enough. For example, McNealy says the year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can delve further by examining the income statement in Exhibit 4. Also, for additional analysis of other factors, consolidated balance sheet(s) are presented in Exhibit 5.

1. Referring to Exhibit 4, compute the annual percentage change in net income per common share-diluted (second numerical line from the bottom) for 1998–1999, 1999–2000, and 2000–2001.

2. Also in Exhibit 4, compute net income/net revenue (sales) for each of the four years. Begin with 1998.

3. What is the major reason for the change in the answer for Question 2 between 2000 and 2001? To answer this question for each of the two years, take the ratio of the major income statement accounts to net revenues (sales).

Cost of sales

Research and development

Selling, general and administrative expense

Provision for income tax

4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 4 and 5.

Exhibit 4

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Exhibit 5

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

page 95 

5. Analyze your results in Question 4 more completely by computing Ratios 1, 2a, 2b,and 3b (all from this chapter) for 2000 and 2001. Actually the answer to Ratio 1 can be found as part of the answer to Question 2, but it is helpful to look at it initially.

What do you think was the main contributing factor to the change in return on stockholders’ equity between 2000 and 2001? Think in terms of the Du Pont system of analysis.

6. The average stock prices for each of the four years shown in Exhibit 4 were as follows:

	1998	11¼
	1999	16¾
	2000	28½
	2001	9½

a. Compute the price-earnings (P/E) ratio for each year. That is, take the stock price shown above and divide by net income per common stock-dilution from Exhibit 4.

b. Why do you think the P/E changed from its 2000 level to its 2001 level? A brief review of P/E ratios can be found under the heading “Price-Earnings Ratio Applied to Earnings per Share” in Chapter 2.

7. The book values per share for the same four years discussed in the preceding question were

	1998	$1.18
	1999	$1.55
	2000	$2.29
	2001	$3.26

a. Compute the ratio of price to book value for each year.

b. Is there any dramatic shift in the ratios worthy of note?

1.