responses

Chapter

Tool Kit	Chapter 3	10/27/15
Analysis of Financial Statements
Financial statements are analyzed by calculating certain key ratios and then comparing them with the ratios of other firms and by examining the trends in ratios over time. We can also combine ratios to make the analysis more revealing, one below are exceptionally useful for this type of analysis.
3-1 Financial Analysis
Input Data:
2016	2015
Year-end common stock price	$27.00	$40.00
Year-end shares outstanding (in millions)	50	50
Tax rate	40%	40%
After-tax cost of capital	11.0%	10.5%
Lease payments	$28	$28
Required sinking fund payments	$20	$20
Figure 3-1
MicroDrive Inc. Balance Sheets and Income Statements for Years Ending December 31
(Millions of Dollars, Except for Per Share Data)
Balance Sheets	2016	2015
Assets
Cash and equivalents	$ 50	$ 60
Short-term investments	-	40
Accounts receivable	500	380
Inventories	1,000	820
Total current assets	$ 1,550	$ 1,300
Net plant and equipment	2,000	1,700
Total assets	$ 3,550	$ 3,000
Liabilities and Equity
Accounts payable	$ 200	$ 190
Notes payable	280	130
Accruals	300	280
Total current liabilities	$ 780	$ 600
Long-term bonds	1,200	1,000
Total liabilities	$ 1,980	$ 1,600
Preferred stock (400,000 shares)	100	100
Common stock (50,000,000 shares)	500	500
Retained earnings	970	800
Total common equity	$ 1,470	$ 1,300
Total liabilities and equity	$ 3,550	$ 3,000
Income Statements	2016	2015
Net sales	$ 5,000	$ 4,760
Costs of goods sold except depreciation	3,800	3,560
Depreciation	200	170
Other operating expenses	500	480
Earnings before interest and taxes (EBIT)	$ 500	$ 550
Less interest	120	100
Pre-tax earnings	$ 380	$ 450
Taxes (40%)	152	180
Net income before preferred dividends	$ 228	$ 270
Preferred dividends	8	8
Net income available to common stockholders	$ 220	$ 262
Other Data
Common dividends	$50	$48
Addition to retained earnings	$170	$214
Lease payments	$28	$28
Bonds' required sinking fund payments	$20	$20
Common stock price per share	$27	$40
Calculated Data: Operating Performance and Cash Flows
2016	2015
Net operating working capital (NOWC) =	$1,050	$790
Total net operating capital =	$3,050	$2,490
Net operating profit after taxes (NOPAT) =	$300	$330
Operating profitability (OP) ratio = NOPAT/Sales =	6.00%	6.93%
Capital requirement(CR) ratio = (Total net operating capital/Sales) =	61.00%	52.31%
Return on invested capital (ROIC) = NOPAT/Total net operating capital =	9.8%	13.3%
Free cash flow (FCF) = NOPAT − Net investment in operating capital =	-$260	N/A
Net cash flow = Net income + Depreciation =	$ 420	$432
Earnings before interest, taxes, depreciation & amortization (EBITDA) = EBIT + Depreciation & amortization =	$700	$720
Market capitalization (# shares x price per share)	$1,350	$2,000
Calculated Data: Per-share Information
2016	2015
Earnings per share (EPS)	$4.40	$5.24
Dividends per share (DPS)	$1.00	$0.96
Book value per share (BVPS)	$29.40	$26.00
Cash flow per share (CFPS)	$8.40	$8.64
EDITDA per share	$14.00	$14.40
Free cash flow per share (FCFPS)	-$5.20	N/A
3-2 Liquidity Ratios	Industry
2016	2015	Average
Liquidity ratios
Current Ratio = CA/CL	2.0	2.2	2.2
Quick Ratio = (CA - Inventories)/CL	0.7	0.8	0.8
3-3 Asset Management Ratios	Industry
2016	2015	Average
Asset Management ratios
Total Asset Turnover = Sales/TA	1.4	1.6	1.8
Fixed Asset Turnover = Sales/Fixed assets	2.5	2.8	3.0
Days Sales Outstanding = Accounts receivable/Daily sales	36.5	29.1 Christopher Buzzard: To calculate the DSO ratio, a 365-day accounting year was used.	30.0
Inventory Turnover = COGS/Inventories	4.0	4.5	5.0
3-4 Debt Management Ratios	Industry
2016	2015	Average
Debt Management ratios
Debt Ratio = Debt-to-Assets Ratio = Total debt/TA	41.7%	37.7%	25.0%
Debt-to-Equity Ratio = Total debt/Total common equity	1.01	0.87	0.46
Market Debt Ratio = Total debt/(Total debt + Market Cap)	52.3%	36.1%	20.0%
Liabilities-to-Assets Ratio = TL/TA	55.8%	53.3%	45.0%
Times Interest Earned = EBIT/Interest expense	4.2	5.5	10.0
EBITDA Coverage Ratio = (EBIT + Depreciation + Lease pmt) (Interest + Principal pmt + Lease pmt)	4.3	5.1	12.0
3-5 Profitability Ratios	Industry
2016	2015	Average
Profitability ratios
Profit Margin = Net income/Sales	4.4%	5.5%	6.2%
Basic Earning Power = EBIT/TA	14.1%	18.3%	20.2%
Return on Assets = Net income/TA	6.2%	8.7%	11.0%
Return on Equity = Net income/Total common equity	15.0%	20.2%	19.0%
3-6 Market Value Ratios	Industry
2016	2015	Average
Market Value ratios
Price-to Earnings Ratio = Price/(Net income/# shares)	6.1	7.6	10.5
Price-to-Cash Flow Ratio = Price (Net income + Depreciation)/# shares	3.2	4.6	6.3
Price-to-EBITDA Ratio = Price (EBIT + Depreciation)/# shares	1.9	2.8	4.0
Market-to-Book Ratio = Price/(Total common equity/#shares)	0.9	1.5	1.8
Market-to-Book Ratio = (Price x #shares)/(Total common equity)	0.9	1.5	1.8
3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis
TREND ANALYSIS
Trend analysis allows you to see how a firm's results are changing over time. For instance, a firm's ROE may be slightly below the benchmark, but if it has been steadily rising over the past four years, that should be seen as a good sign.
A trend analysis and graph have been constructed on this data regarding MicroDrive's ROE over the past 5 years. (MicroDrive and indusry average data for earlier years has been provided.)
ROE
MicroDrive	Industry
2012	15.0%	14.0%
2013	18.0%	15.0%
2014	21.0%	18.0%
2015	20.2%	17.0%
2016	15.0%	19.0%
Figure 3-2
MicroDrive, Inc.: Return on Common Equity
COMMON SIZE ANALYSIS
In common size income statements, all items for a year are divided by the sales for that year.
Figure 3-3
MicroDrive Inc.: Common Size Income Statements
Industry Composite	MicroDrive
2016	2016	2015
Net sales	100.0%	100.0%	100.0%
Costs of goods sold except depreciation	75.5%	76.0%	74.8%
Depreciation	3.0%	4.0%	3.6%
Other operating expenses	10.0%	10.0%	10.1%
Earnings before interest and taxes (EBIT)	11.5%	10.0%	11.6%
Less interest	1.2%	2.4%	2.1%
Pre-tax earnings	10.4%	7.6%	9.5%
Taxes (40%)	4.1%	3.0%	3.8%
Net income before preferred dividends	6.2%	4.6%	5.7%
Preferred dividends	0.0%	0.2%	0.2%
Net income available to common stockholders	6.2%	4.4%	5.5%
In common sheets, all items for a year are divided by the total assets for that year.
Figure 3-4
MicroDrive Inc.: Common Size Balance Sheets
Industry Composite	MicroDrive
2016	2016	2015
Assets
Cash and equivalents	1.8%	1.4%	2.0%
Short-term investments	0.0%	0.0%	1.3%
Accounts receivable	14.0%	14.1%	12.7%
Inventories	26.3%	28.2%	27.3%
Total current assets	42.1%	43.7%	43.3%
Net plant and equipment	57.9%	56.3%	56.7%
Total assets	100.0%	100.0%	100.0%
Liabilities and Equity
Accounts payable	7.0%	5.6%	6.3%
Notes payable	0.0%	7.9%	4.3%
Accruals	12.3%	8.5%	9.3%
Total current liabilities	19.3%	22.0%	20.0%
Long-term bonds	25.4%	33.8%	33.3%
Total liabilities	44.7%	55.8%	53.3%
Preferred stock	0.0%	2.8%	3.3%
Total common equity	55.3%	41.4%	43.3%
Total liabilities and equity	100.0%	100.0%	100.0%
PERCENT CHANGE ANALYSIS
In percent change analysis, all items are divided by the that item's value in the beginning, or base, year.
Figure 3-5
MicroDrive Inc.: Income Statement Percent Change Analysis
Base year =	2015	Percent Change in
2016
Net sales	5.0%
Costs of goods sold except depreciation	6.7%
Depreciation	17.6%
Other operating expenses	4.2%
Earnings before interest and taxes (EBIT)	(9.1%)
Less interest	20.0%
Pre-tax earnings	(15.6%)
Taxes (40%)	(15.6%)
Net income before preferred dividends	(15.6%)
Preferred dividends	0.0%
Net income available to common stockholders	(16.0%)
MicroDrive, Inc.: Balance Sheet Percent Change Analysis (not in textbook)
Base year =	2015	Percent Change in
2016
Assets
Cash and equivalents	(16.7%)
Short-term investments	(100.0%)
Accounts receivable	31.6%
Inventories	22.0%
Total current assets	19.2%
Net plant and equipment	17.6%
Total assets	18.3%
Liabilities and Equity
Accounts payable	5.3%
Notes payable	115.4%
Accruals	7.1%
Total current liabilities	30.0%
Long-term bonds	20.0%
Total liabilities	23.8%
Preferred stock (400,000 shares)	0.0%
Common stock (50,000,000 shares)	0.0%
Retained earnings	21.3%
Total common equity	13.1%
Total liabilities and equity	18.3%
3-8 DuPont Analysis
ROE =	Profit margin x	TA turnover x	Equity multiplier
MicroDrive	2016	15.0%	4.40%	1.41	2.415
MicroDrive	2015	20.2%	5.50%	1.59	2.308
Industry Average	20.3%	6.20%	1.80	1.818
Suppose MicroDrive can improve its total asset turnover ratio.
Improved TA turover ratio =	1.8
ROE =	Profit margin x	TA turnover x	Equity multiplier
19.1%	4.40%	1.80	2.415

MicroDrive

2012 2013 2014 2015 2016 0.15 0.18 0.21 0.20153846153846153 0.14965986394557823 Industry

2012 2013 2014 2015 2016 0.14000000000000001 0.15 0.18 0.17 0.19

ROE (%)

MicroDrive

2012 2013 2014 2015 2016 0.15 0.18 0.21 0.20153846153846153 0.14965986394557823 Industry

2012 2013 2014 2015 2016 0.14000000000000001 0.15 0.18 0.17 0.19

ROE (%)

3-2

SECTION 3-2
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. What is its current ratio? Its quick ratio?
Cash	$40
Accounts receivable	$30
Inventories	$100
Net fixed assets	$500
Total	$670
Accounts payable	$20
Accruals	$10
ST debt	$25
LT debt	$200
Total common equity	$415
$670
Current assets	$170
Current liabilities	$55
Current ratio	3.1
Current assets − Inventories	$70
Current liabilities	$55
Quick ratio	1.3
A company has current liabilities of $800 million, and its current ratio is 2.5. What is its level of current assets? If this firm’s quick ratio is 2, how much inventory does it have?
Current liabilities ($M)	$800
Current ratio	2.5
Current assets ($M)	$2,000
Current liabilities ($M)	$800
Current ratio	2.5
Quick ratio	2
Current assets - Inventories ($M)	$1,600
Inventories ($M)	$400

3-3

SECTION 3-2
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Calculate the following ratios: total assets turnover, fixed assets turnover, days sales outstanding (based on a 365 day year), inventory turnover. Hint: This is the same company used in the previous Self-Test.
Cash	$40
Accounts receivable	$30
Inventories	$100
Net fixed assets	$500
Total assets	$670
Accounts payable	$20
Accruals	$10
ST debt	$25
LT debt	$200
Total common equity	$415
$670
Sales	$820
COGS (excluding depreciation)	$450
Depreciation	$50
Other operating expenses	$100
EBIT	$220
Interest expense	$20
Pre-tax earnings	$200
Tax rate	40%
Tax expense	$80
Net income	$120
Days in year	365
Sales	$820
Total assets	$670
Total assets turnover	1.2
Sales	$820
Fixed assets	$500
Fixed assets turnover	1.6
Daily average sales	$2.25
Accounts receivable	$30
Days sales outstanding	13.4
COGS including depreciation	$500
Inventories	$100
Fixed assets turnover	5.0
A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts receivable. What is its inventory turnover ratio?
Annual Sales ($M)	$200
Costs of good sold ($M)	$180
Inventory ($M)	$40
Accounts receivable ($M)	$60
Inventory turnover	4.5
Annual Sales ($M)	$200
Inventory ($M)	$40
Accounts receivable ($M)	$60
Days sales outstanding	109.5

3-4

SECTION 3-4
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Calculate the following ratios: Debt-to-assets ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest earned ratio, and EBITDA coverage ratio (the firm has no lease payments or required principal payments). Hint: This is the same company used in the previous Self-Test.
Cash	$40
Accounts receivable	$30
Inventories	$100
Net fixed assets	$500
Total assets	$670
Accounts payable	$20
Accruals	$10
ST debt	$25
LT debt	$200
Total common equity	$415
$670
Sales	$820
COGS (excluding depreciation)	$450
Depreciation	$50
Other operating expenses	$100
EBIT	$220
Interest expense	$20
Pre-tax earnings	$200
Tax rate	40%
Tax expense	$80
Net income	$120
Days in year	365
Lease payments	$0
Required principal payments	$0
Total debt	$225
Total assets	$670
Debt-to-assets ratio	33.6%
Total debt	$225
Total common equity	$415
Debt-to-equity ratio	54.2%
Total liabilities	$255
Total assets	$670
Liabilities-to-assets ratio	38.1%
EBIT	$220
Interest expense	$20
Times-interest-earned ratio	11.0
Suppose the previous company has 100 shares of stock with a price of $15 per share. What is its market debt ratio (assume the market value of debt is close to the book value)? How does this compare with the previously calculated debt-to-assets ratio? Does the market debt ratio imply that the company is more or less risky than the debt-to-assets ratio indicated?
Number of shares	100
Price per share	$15
Total debt	$225
Market value of equity	$1,500
Market debt ratio	13.0%
Notice that the market debt ratio is much less than the debt ratio based on book values, implying that the firm is less risky than indicated by the ratio based on book values.
A company has EBITDA of $600 million, interest payments of $60 million, lease payments of $40 million, and required principal payments (due this year) of $30 million. What is its EBITDA coverage ratio?
EBITDA ($M)	$600
Interest payments	$60
Lease payments	$40
Principal payments	$30
EBITDA coverage	4.9

3-5

SECTION 3-5
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, interest expense = $20, and tax rate = 40%. Net profit margin, operating profit margin, basic earning power ratio, return on total assets , and return on common equity. Hint: This is the same company used in the previous Self-Test.
Cash	$40
Accounts receivable	$30
Inventories	$100
Net fixed assets	$500
Total assets	$670
Accounts payable	$20
Accruals	$10
ST debt	$25
LT debt	$200
Total common equity	$415
$670
Sales	$820
COGS (excluding depreciation)	$450
Depreciation	$50
Other operating expenses	$100
EBIT	$220
Interest expense	$20
Pre-tax earnings	$200
Tax rate	40%
Tax expense	$80
Net income	$120
Net income	$120
Sales	$820
Net profit margin	14.6%
EBIT	$220
Sales	$820
Operating profit margin	26.8%
EBIT	$220
Total assets	$670
Basic earnings power ratio	32.8%
Net income	$120
Total assets	$670
Return on total assets	17.9%
Net income	$120
Total common equity	$415
Return on common equity	28.9%
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion, financed half by debt and half by common equity. What is its profit margin? What is its ROA? What is its ROE?
Sales ($B)	$200
Net income ($B)	$10
Total assets ($B)	$100
Debt ratio	50%
Profit margin	5.00%
Sales ($B)	$200
Net income ($B)	$10
Total assets ($B)	$100
Debt ratio	50%
ROA	10.00%
Sales ($B)	$200
Net income ($B)	$10
Total assets ($B)	$100
Debt ratio	50%
ROE	20.00%

3-6

SECTION 3-6
SOLUTIONS TO SELF-TEST
A company has $6 billion of net income, $2 billion of depreciation and amortization, $80 billion of common equity, and one billion shares of stock. If its stock price is $96 per share, what is its price/earnings ratio? Its price/cash flow ratio? Its market/book ratio?
Net income ($B)	$6
Amortization and depreciation ($B)	$2
Common equity	$80
Number of shares ($B)	1
Stock price per share	$96
Earnings per share	$6
P/E ratio	16.00
Cash flow	$8.00
Cash flow per share	8.00
Price/cash flow	12.00
Book value per share	80.00
Market/Book	1.20

3-8

SECTION 3-8
SOLUTIONS TO SELF-TEST
A company has a profit margin of 6%, a total asset turnover ratio of 2, and an equity multiplier of 1.5. What is its ROE?
Profit margin	6.0%
Total asset turnover	2.0
Equity multiplier	1.5
ROE	18.0%

Mini Case Data

10/27/15
Mini Case Data
Input Data:
2014	2015	2016 Bart Kreps: Projections
Year-end common stock price	$8.50	$6.00	$12.17
Year-end shares outstanding	100,000	100,000	250,000
Tax rate	40%	40%	40%
Lease payments	$40,000	$40,000	$40,000
Balance Sheets
Assets	2014	2015	2016
Cash and equivalents	$9,000	$7,282	$14,000
Short-term investments	$48,600	$20,000	$71,632
Accounts receivable	$351,200	$632,160	$878,000
Inventories	$715,200	$1,287,360	$1,716,480
Total current assets	$1,124,000	$1,946,802	$2,680,112
Gross Fixed Assets	$491,000	$1,202,950	$1,220,000
Less Accumulated Dep.	$146,200	$263,160	$383,160
Net Fixed Assets	$344,800	$939,790	$836,840
Total Assets	$1,468,800	$2,886,592	$3,516,952
Liabilities and Equity
Accounts payable	$145,600	$324,000	$359,800
Notes payable	$200,000	$720,000	$300,000
Accruals	$136,000	$284,960	$380,000
Total current liabilities	$481,600	$1,328,960	$1,039,800
Long-term bonds	$323,432	$1,000,000	$500,000
Total liabilities	$805,032	$2,328,960	$1,539,800
Common stock (100,000 shares)	$460,000	$460,000	$1,680,936
Retained earnings	$203,768	$97,632	$296,216
Total common equity	$663,768	$557,632	$1,977,152
Total liabilities and equity	$1,468,800	$2,886,592	$3,516,952
Income Statements
2014	2015	2016
Net sales	$3,432,000	$5,834,400	$7,035,600
Costs of Goods Sold Except Depr.	$2,864,000	$4,980,000	$5,800,000
Depreciation and amortization	$18,900	$116,960	$120,000
Other Expenses	$340,000	$720,000	$612,960
Total Operating Cost	$3,222,900	$5,816,960	$6,532,960
Earnings before interest and taxes (EBIT)	$209,100	$17,440	$502,640
Less interest	$62,500	$176,000	$80,000
Pre-tax earnings	$146,600	($158,560)	$422,640
Taxes (40%)	$58,640	($63,424)	$169,056
Net Income before preferred dividends	$87,960	($95,136)	$253,584
EPS	$0.880	($0.951)	$1.014
DPS	$0.220	$0.110	$0.220
Book Value Per Share	$6.638	$5.576	$7.909