Case study

Managementchap3.docx

Financial Analysis

LEARNING OBJECTIVES

LO 3-1	Ratio analysis provides a meaningful comparison of a company to its industry.
LO 3-2	Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization.
LO 3-3	The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders.
LO 3-4	Trend analysis shows company performance over time.
LO 3-5	Reported 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 (Speed Stick, Lady Speed Stick, etc.).

For those of you who decide to stay home and clean your apartment or dorm room, Colgate-Palmolive will provide you with Ajax, Fab, 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 over the last three years. Its profit margin in 2014 was 13.5 percent, and its return on assets was 31.5 percent. While these numbers are higher than those of the average company, the 2014 number that blows analysts away is its return on stockholders’ equity of 167.8 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-asset ratio of 81 percent. This means that the firm’s debt represents 81 percent of total assets and stockholders’ equity only 19 percent. Almost any amount of profit will appear high in regard to the low value of stockholders’ equity.

In contrast, its main competitor, Procter & Gamble, has only a 17.5 percent return on stockholders’ equity, partially because it is heavily financed by stockholders’ equity at 66.2 percent while its debt-to-asset ratio is 33.8 percent. This may be good or bad. This kind of analysis will be found in the financial ratios discussion 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 16,000 companies 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

4. Receivable turnover

5. Average collection period

6. Inventory turnover

7. Fixed asset turnover

8. Total asset turnover

C. Liquidity ratios

9. Current ratio

10. Quick ratio

D. Debt utilization ratios

11. Debt to total assets

12. Times interest earned

13. 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

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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 3-1 Financial statement for ratio analysis

SAXTON COMPANY Income Statement For the Year Ended December 31, 2015
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
Extraordinary loss	200,000
Net income before taxes	$ 300,000
Taxes (33%)	100,000
Net income	$ 200,000

* Includes $50,000 in lease payments.

Balance Sheet As of December 31, 2015
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.

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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:

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 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 3-1 Du Pont analysis

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As an example of the Du Pont analysis, Table 3-2 on the next page compares two well-known retail store chains, Walmart and Abercrombie & Fitch. In 2014, Abercrombie was more profitable in terms of profit margins (4.2 percent versus 3.3 percent). However, Walmart had a 19.5 percent return on equity versus 10.5 percent for Abercrombie. Why the reversal in performance? It comes back to the Du Pont system of analysis. Walmart turned over its assets 3.62 times a year versus a slower 2.15 times for Abercrombie.

Walmart was following the philosophy of its late founder Sam Walton: Give the customer a bargain in terms of low prices (and low profit margins) but move the merchandise quickly. Walmart was able to turn a low return on sales (profit margin) into a good return on assets. Furthermore, its higher debt ratio (37.7 percent for Walmart versus 13.4 percent for Abercrombie) allowed Walmart to turn its higher return on assets into an even higher relative return on equity (19.5 percent versus 10.5 percent). For some firms, a higher debt ratio might indicate additional risk, but for stable Walmart, this is not the case.

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 3-2 Return on Equity: Walmart vs. Abercrombie & Fitch using the Du Pont Method of Analysis, 2014

Data: December 31, 2014

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. Further analysis might call for 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.

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Table 3-3 Ratio analysis

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.

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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 on the next page, 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 on page 67 , 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 took over as chairman and chief executive officer at IBM and began 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.

Figure 3-2 Trend analysis

A. Profit margin

B. Total asset turnover

In 2003, Apple Computer began its amazing run over the next 10 years, creating the iPod, annual versions of the iPhone, the iPad, and 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-asset ratio of 72.5 percent in its capital structure while Apple has a 24 percent debt-to-asset ratio. In addition, IBM has been buying back billions of dollars of stock in the market over the last 10 years and has reduced stockholders’ equity on its balance sheet. Both the debt and stock repurchases have inflated IBM’s return on equity.

Apple was 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 raise its dividends as well as buy back some stock. In contrasting the two companies, we should point out that while IBM’s revenues were stagnant from 2004 to 2014, Apple grew its revenues from $8.2 billion in 2004 to $182.795 billion, almost doubling IBM’s revenues of $94.5 billion.

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Table 3-4 Trend analysis in the computer industry

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.

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. One of the major concerns of many economists is that the United States will suffer from an inflationary spiral before 2020 because of all the money that the Federal Reserve has pumped into the economy to help pull the country out of its financial crisis. So far there is no sign of rising inflation, but it pays to be vigilant.

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Finance in ACTION Managerial Are Financial Analysts Friends or Foes to Investors? Reader Beware!

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 be. 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.

www.goldmansachs.com

www.ml.com

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An Illustration

The Stein Corporation shows the accompanying income statement for 2015 in Table 3-5 . At year-end the firm also has 100 units still in inventory at $1 per unit.

Table 3-5 Stein Corporation Income Statement for 2015

STEIN CORPORATION Net Income for 2015
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 (40%)	28
Aftertax income	$ 42

Assume that in the year 2016 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, 2015 inventory will be written off against year 2016 sales revenue.

In Table 3-6 , the company appears to have increased profit by $11 compared to that shown in Table 3-5 (from $42 to $53) 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.

Table 3-6 Stein Corporation Income Statement for 2016

STEIN CORPORATION Net Income for 2016
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 (40%)	35
Aftertax income	$ 53

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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 eight 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

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

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.

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, and also 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.

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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, that boomed in the highly inflationary environment of the late 1970s fell off sharply a decade later, as softening prices caused less 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. This happened in Russia, Asia, and other foreign countries in 1998, and it has become a worry in Russia and Europe in 2015. One of the negative consequences is that debt has to be repaid with more expensive currency rather than with cheaper money under inflationary conditions. The same phenomenon happened in the United States from 2007 to 2009 and is a continuing concern of the Federal Reserve Board. Monetary authorities would rather have a low-inflation economy 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 on the next page. Both firms had identical operating performances for 2015—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 2014, Company B would be thought to be showing substantial growth in 2015 with net income of $700,000, while Company A is reporting a “flat” or no-growth year in 2015. 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 could 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 3-8

INCOME STATEMENTS For the Year 2015
	Conservative Firm A	High Reported Income 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
Extraordinary loss	100,000	—
Net income before taxes	$ 400,000	$1,000,000
Taxes (30%)	120,000	300,000
Net income	$ 280,000	$ 700,000
Extraordinary loss (net of tax)	—	70,000
Net income transferred to retained earnings	$ 280,000	$ 630,000

Cost of Goods Sold The conservative firm (Company A) may well be using LIFO accounting 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.

Extraordinary Gains/Losses Nonrecurring gains or losses may occur from the sale of corporate fixed assets, lawsuits, or similar nonrecurring events. Some analysts argue that such extraordinary events should be included in computing the current income of the firm, while others would leave them off in assessing operating performance. Unfortunately, nonrecurring losses are treated inconsistently despite attempts by the accounting profession to ensure uniformity. The conservative Firm A has written off its $100,000 extraordinary loss against normally reported income, while Firm B carries a subtraction against net income only after the $700,000 amount has been reported. Both had similar losses of $100,000, but Firm B’s loss is shown net of tax implications at $70,000.

Extraordinary gains and losses happen among large companies more often than you might think. General Motors has had “nonrecurring” losses four times in the last decade. This, in part, led to its decline as a major corporation. In the current age of mergers, tender offers, and buyouts, understanding the finer points of extraordinary gains and losses becomes even more important.

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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 they 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 also 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 their 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 one should do to others what they would wish done to themselves. Like many successful business people, 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: R.G. Eccles, I. Ioannou, and G. Serafeim, “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance,” NBER Working Paper No. 17950, 2012.

Net Income

Firm A has reported net income of $280,000, while Firm B claims $700,000 before subtraction of extraordinary losses. The $420,000 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.

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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, the presence of extraordinary gains and losses, and so on. The well-trained financial analyst must be alert to all of these factors.

LIST OF TERMS

profitability ratios 58

profit margin

return on asset

return on equity

asset utilization ratios 58

receivable turnover

average collection period

inventory turnover

fixed asset turnover

total asset turnover

liquidity ratios 58

current ratio

quick ratio

debt utilization ratios 58

debt to total assets

times interest earned

fixed charge coverage

Du Pont system of analysis 60

trend analysis 65

inflation 67

replacement costs 69

disinflation 70

deflation 71

LIFO 72

FIFO 72

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)

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)

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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.

All 13 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.

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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

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

* Includes $40,000 in lease payments.

Solutions

1. a.

2. Profitability ratios

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Asset utilization ratios

Liquidity ratios

10.

Debt utilization ratios

11.

12.

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

13.

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

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

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Fixed charges = Lease payments = Interest

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

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. Zhivago 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?

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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

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 assets 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?