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The Analysis of Financial Statements

6 The Analysis of

Financial Statements Ratios are tools, and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So too, we need to be skilled

with the financial tools we use. —DIANNE MORRISON

Chief Executive Officer, R.E.C. Inc.

C H A P T E R

192

The preceding chapters have covered in detail the form and content of the four basic financial statements found in the annual reports of U.S. firms: the balance sheet, the income statement, the statement of stockholders’ equity, and the statement of cash flows; and Chapter 5 presented an in-depth approach to evaluating the quality of reported financial statement information. This chapter will develop tools and tech- niques for the interpretation of financial statement information.

Objectives of Analysis Before beginning the analysis of any firm’s financial statements, it is necessary to spec- ify the objectives of the analysis. The objectives will vary depending on the perspective of the financial statement user and the specific questions that are addressed by the analysis of the financial statement data.

A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds. The questions raised in a credit analysis should include:

• What is the borrowing cause? What do the financial statements reveal about the reason a firm has requested a loan or the purchase of goods on credit?

• What is the firm’s capital structure? How much debt is currently outstanding? How well has debt been serviced in the past?

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• What will be the source of debt repayment? How well does the company manage working capital? Is the firm generating cash from operations?

The credit analyst will use the historical record of the company, as presented in the financial statements, to answer such questions and to predict the potential of the firm to satisfy future demands for cash, including debt service.

The investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation. The investment analyst poses such questions as:

• What is the company’s performance record, and what are the future expectations? What is its record with regard to growth and stability of earnings? Of cash flow from operations?

• How much risk is inherent in the firm’s existing capital structure? What are the expected returns, given the firm’s current condition and future outlook?

• How successfully does the firm compete in its industry, and how well positioned is the company to hold or improve its competitive position?

The investment analyst also uses historical financial statement data to forecast the future. In the case of the investor, the ultimate objective is to determine whether the investment is sound.

Financial statement analysis from the standpoint of management relates to all of the questions raised by creditors and investors because these user groups must be sat- isfied in order for the firm to obtain capital as needed. Management must also consider its employees, the general public, regulators, and the financial press. Management looks to financial statement data to determine:

• How well has the firm performed and why? What operating areas have contributed to success and which have not?

• What are the strengths and weaknesses of the company’s financial position? • What changes should be implemented in order to improve future performance?

Financial statements provide insight into the company’s current status and lead to the development of policies and strategies for the future. It should be pointed out, however, that management also has responsibility for preparing the financial statements. The analyst should be alert to the potential for management to influence the outcome of financial statement reporting in order to appeal to creditors, investors, and other users. It is important that any analysis of financial statements include a careful reading of the notes to the financial statements, and it may be help- ful to supplement the analysis with other material in the annual report and with other sources of information apart from the annual report.

Sources of Information The financial statement user has access to a wide range of data sources in the analysis of financial statements. The objective of the analysis will dictate to a considerable degree not only the approach taken in the analysis but also the particular resources that should be consulted in a given circumstance.The beginning point, however, should

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always be the financial statements themselves and the notes to the financial state- ments. In addition, the analyst will want to consider the following resources.

Proxy Statement The proxy statement, discussed in Chapter 1, contains useful information about the board of directors, director and executive compensation, option grants, audit-related matters, related party transactions, and proposals to be voted on by shareholders.

Auditor’s Report The report of the independent auditor contains the expression of opinion as to the fair- ness of the financial statement presentation. Most auditor’s reports are unqualified, which means that in the opinion of the auditor the financial statements present fairly the financial position, the results of operations, and the cash flows for the periods cov- ered by the financial statements.A qualified report, an adverse opinion, or a disclaimer of opinion, is rare and therefore suggests that a careful evaluation of the firm be made. An unqualified opinion with explanatory language should be reviewed carefully by the analyst. In addition, the analyst should read the report and certification regarding the effectiveness of the internal controls over financial reporting.

Management Discussion and Analysis The Management Discussion and Analysis of the Financial Condition and Results of Operations, discussed in Chapter 1, is a section of the annual report that is required and monitored by the Securities and Exchange Commission (SEC). In this section, management presents a detailed coverage of the firm’s liquidity, capital resources, and operations. The material can be especially helpful to the financial analyst because it includes facts and estimates not found elsewhere in the annual report. For example, this report is expected to cover forward-looking information such as projections of capital expenditures and how such investments will be financed. There is detail about the mix of price relative to volume increases for products sold. Management must dis- close any favorable or unfavorable trends and any significant events or uncertainties that relate to the firm’s historical or prospective financial condition and operations.

Supplementary Schedules Certain supplementary schedules are required for inclusion in an annual report and are frequently helpful to the analysis. For example, companies that operate in several unrelated lines of business provide a breakdown of key financial figures by operating segment. (The analysis of segmental data is covered in the appendix to this chapter.)

Form 10-K and Form 10-Q Form 10-K is an annual document filed with the SEC by companies that sell securities to the public and contains much of the same information as the annual report issued to shareholders. It also shows additional detail that may be of interest to the financial ana- lyst, such as schedules listing information about management, a description of material litigation and governmental actions, and elaborations of some financial statement disclo- sures. Form 10-Q, a less extensive document, provides quarterly financial information.

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1One resource that is commonly available in both public and academic libraries is the Infotrak—General Business Index. This CD-ROM database provides indexing to approximately 800 business, trade, and management journals; it has company profiles, investment analyst reports, and a wide range of business news. To learn about the availability and use of this system or other search systems and databases, consult the library’s reference librarian or the business reference librarian.

Both reports, as well as other SEC forms filed by companies, are available through the SEC Electronic Data Gathering,Analysis, and Retrieval (EDGAR) database.

Other Sources There is a considerable body of material outside of the corporate annual report that can contribute to an analysis of financial statements. Most academic libraries and many public libraries have available computerized search systems and computerized data- bases that can greatly facilitate financial analysis.1 Although not a replacement for the techniques that are discussed in this chapter, these research materials supplement and enhance the analytical process as well as provide time-saving features. Computerized financial statement analysis packages are also available that perform some of the ratio calculations and other analytical tools described in this chapter. (See the financial statement analysis template available at www.prenhall.com/fraser.)

Other general resources useful as aids in the analysis of financial statements can be found in the general reference section of public and university libraries. The following sources provide comparative statistical ratios to help determine a company’s relative position within its industry:

1. Dun & Bradstreet Information Services, Industry Norms and Key Business Ratios. Murray Hill, NJ.

2. The Risk Management Association, Annual Statement Studies. Philadelphia, PA. 3. Standard & Poor’s Corporation, Ratings Handbook and Industry Surveys. New

York, NY. 4. Gale Research Inc., Manufacturing U.S.A. Industry Analyses. Detroit, MI.

When analyzing a company it is also important to review the annual reports of suppliers, customers, and competitors of that company. The bankruptcy of a supplier could affect the firm’s supply of raw materials, while the bankruptcy of a customer could negatively impact the collection of accounts receivable and future sales. Knowing how one company compares financially to its competitors, and understanding other factors such as innovation and customer service provided by the competition allows for a better analysis to predict the future prospects of the firm.

Additional resources for comparative and other information about companies can be found on the following free Internet sites:2

1. Yahoo!, http://finance.yahoo.com/ 2. Market Watch, www.marketwatch.com 3. Reuters, www.investor.reuters.com

Many other Internet sites charge subscription fees to access information, but public and university libraries often subscribe, making this information free to the public. Libraries are currently in the process of converting information from hard

2Internet sites are constantly changing; therefore, the content and Web addresses may change after publication of this book.

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copy format to online databases; the following useful references may be available at a local library:

1. Moody’s Investor Service, Mergent Manuals and Mergent Handbook. New York, NY. (Formerly Moody’s Manuals and Handbook. The online version is Mergent FIS Online and Mergent Industry Surveys Disc.)

2. Standard & Poor’s Corporation, Corporation Records, The Outlook, Stock Reports, and Stock Guide. New York, NY. (The online version is Standard and Poor’s Net Advantage.)

3. Value Line, Inc., The Value Line Investment Survey. New York, NY (www.valueline. com).

4. Zack’s Investment Research Inc., Earnings Forecaster. Chicago, IL (www.zacks. com).

5. Gale Research Inc., Market Share Reporter. Detroit, MI. 6. Dow Jones-Irwin, The Financial Analyst’s Handbook. Homewood, IL. 7. For mutual funds: Morningstar, Morningstar Mutual Funds. Chicago, IL. (www.

morningstar.com).

The following Web sites contain useful investment and financial information includ- ing company profile and stock prices; some sites charge fees for certain information:

1. SEC EDGAR Database, www.sec.gov/edgarhp.htm 2. Hoover’s Corporate Directory, www.hoovers.com/ 3. Dun & Bradstreet, www.dnb.com/ 4. Standard & Poor’s Ratings Services, www.standardpoor.com/ratings/ 5. CNN Financial Network, www.money.cnn/

Articles from current periodicals such as BusinessWeek, Forbes, Fortune, and the Wall Street Journal can add insight into the management and operations of individual firms as well as provide perspective on general economic and industry trends. The financial analysis described in this chapter should be used in the context of the eco- nomic and political environment in which the company operates. Reading about the economy regularly in business publications allows the analyst to assess the impact of unemployment, inflation, interest rates, gross domestic product, productivity, and other economic indicators on the future potential of particular firms and industries.

Tools and Techniques Various tools and techniques are used by the financial statement analyst in order to convert financial statement data into formats that facilitate the evaluation of a firm’s financial condition and performance, both over time and in comparison with industry competitors. These include common-size financial statements, which express each account on the balance sheet as a percentage of total assets and each account on the income statement as a percentage of net sales; financial ratios, which standardize finan- cial data in terms of mathematical relationships expressed in the form of percentages or times; trend analysis, which requires the evaluation of financial data over several accounting periods; structural analysis, which looks at the internal structure of a busi- ness enterprise; industry comparisons, which relate one firm with averages compiled for the industry in which it operates; and most important of all, common sense and

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judgment. These tools and techniques will be illustrated by walking through a financial statement analysis of R.E.C. Inc. This first part will cover number crunching—the calculation of key financial ratios. The second part will provide the integration of these numbers with other information—such as the statement of cash flows from Chapter 4 and background on the economy and the environment in which the firm operates—in order to perform an analysis of R.E.C. Inc. over a five-year period and to assess the firm’s strengths, weaknesses, and future prospects.

Common-Size Financial Statements Common-size financial statements were covered in Chapters 2 and 3. Exhibits 2.2 (p. 47) and 3.3 (p. 90) present the common-size balance sheet and common-size income state- ment, respectively, for R.E.C. Inc. The information from these statements presented in prior chapters is summarized again, and will be used in the comprehensive analysis illus- trated in this chapter.

From the common-size balance sheet in Exhibit 2.2, it can be seen that inventories have become more dominant over the five-year period in the firm’s total asset struc- ture and in 2007 comprised almost half (49.4%) of total assets. Holdings of cash and marketable securities have decreased from a 20% combined level in 2003 and 2004 to about 10% in 2007. The company has elected to make this shift in order to accommo- date the inventory requirements of new store openings. The firm has opened 43 new stores in the past two years, and the effect of this market strategy is also reflected in the overall asset structure. Buildings, leasehold improvements, equipment, and accumu- lated depreciation and amortization have increased as a percentage of total assets. On the liability side, the proportion of debt required to finance investments in assets has risen, primarily from long-term borrowing.

The common-size income statement shown in Exhibit 3.3 reveals the trends of expenses and profit margins. Cost of goods sold has increased slightly in percentage terms, resulting in a small decline in the gross profit percentage.To improve this margin, the firm will either have to raise its own retail prices, change the product mix, or figure ways to reduce costs on goods purchased for resale. In the area of operating expenses, depreciation and amortization have increased relative to sales, again reflecting costs associated with new store openings. Selling and administrative expenses rose in 2005, but the company controlled these costs more effectively in 2006 and 2007 relative to overall sales. Operating and net profit percentages will be discussed more extensively in connection with the five-year trends of financial ratios later in the chapter. It can be seen from the common-size income statements that both profit percentages deterio- rated through 2006 and rebounded in the most recent year as R.E.C. Inc. enjoyed the benefits of an economic recovery and profits from expansion.

Key Financial Ratios The R.E.C. Inc. financial statements will be used to compute a set of key financial ratios for the years 2007 and 2006. Later in the chapter, these ratios will be evaluated in the context of R.E.C. Inc.’s five-year historical record and in comparison with industry com- petitors.The four categories of ratios to be covered are (1) liquidity ratios, which measure a firm’s ability to meet cash needs as they arise; (2) activity ratios, which measure the liq- uidity of specific assets and the efficiency of managing assets; (3) leverage ratios, which

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3Analysts sometimes use an average number in the denominator of ratios that have a balance sheet account in the denominator. This is preferable when the company’s balance sheet accounts vary significantly from one year to the next. The illustrations in this chapter do not use an average number in the denominator.

measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges; and (4) profitability ratios, which measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity.

Before delving into the R.E.C. Inc. financial ratios, it is important to introduce a word of caution in the use of financial ratios generally. Although extremely valuable as analyti- cal tools, financial ratios also have limitations.They can serve as screening devices, indicate areas of potential strength or weakness, and reveal matters that need further investigation. But financial ratios do not provide answers in and of themselves, and they are not predic- tive. Financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. It should also be noted that there is no one definitive set of key financial ratios, there is no uniform definition for all ratios,and there is no standard that should be met for each ratio.Finally, there are no “rules of thumb”that apply to the interpretation of financial ratios.Each situation should be eval- uated within the context of the particular firm, industry, and economic environment.3

Figures from the R.E.C. Inc. Consolidated Balance Sheets, Statements of Earnings, and Statements of Cash Flows, Exhibits 6.1 (pp. 199–200) and 6.2 (p. 217), are used to illustrate the calculation of financial ratios for 2007 and 2006, and these financial ratios will subsequently be incorporated into a five-year analysis of the firm.

Liquidity Ratios: Short-Term Solvency Current Ratio

2007 2006 Current assets 65,846 � 2.40 times 56,264 � 2.75 times

Current liabilities 27,461 20,432

The current ratio is a commonly used measure of short-run solvency, the ability of a firm to meet its debt requirements as they come due. Current liabilities are used as the denominator of the ratio because they are considered to represent the most urgent debts, requiring retirement within one year or one operating cycle.The available cash resources to satisfy these obligations must come primarily from cash or the conversion to cash of other current assets. Some analysts eliminate prepaid expenses from the numerator because they are not a potential source of cash but, rather, represent future obligations that have already been satisfied.The current ratio for R.E.C. Inc. indicates that at year-end 2007 current assets covered current liabilities 2.4 times, down from 2006. In order to inter- pret the significance of this ratio it will be necessary to evaluate the trend of liquidity over a longer period and to compare R.E.C. Inc.’s coverage with industry competitors. It is also essential to assess the composition of the components that comprise the ratio.

As a barometer of short-term liquidity, the current ratio is limited by the nature of its components. Remember that the balance sheet is prepared as of a particular date, and the actual amount of liquid assets may vary considerably from the date on which the balance sheet is prepared. Further, accounts receivable and inventory may not be truly liquid. A firm could have a relatively high current ratio but not be able to

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EXHIBIT 6.1 R.E.C. Inc. Consolidated Balance Sheets at December 31, 2007 and 2006 (in Thousands)

2007 2006

Assets

Current Assets

Cash $ 4,061 $ 2,382

Marketable securities (Note A) 5,272 8,004

Accounts receivable, less allowance for doubtful accounts of $448 in 2007 and $417 in 2006 8,960 8,350

Inventories (Note A) 47,041 36,769

Prepaid expenses 512 759

Total current assets 65,846 56,264

Property, Plant, and Equipment (Notes A, C, and E)

Land 811 811

Buildings and leasehold improvements 18,273 11,928

Equipment 21,523 13,768

40,607 26,507

Less accumulated depreciation and amortization 11,528 7,530

Net property, plant, and equipment 29,079 18,977

Other Assets (Note A) 373 668

Total Assets $95,298 $75,909

Liabilities and Stockholders’ Equity

Current Liabilities

Accounts Payable $14,294 $ 7,591

Notes payable—banks (Note B) 5,614 6,012

Current maturities of long-term debt (Note C) 1,884 1,516

Accrued liabilities 5,669 5,313

Total current liabilities 27,461 20,432

Deferred Federal Income Taxes (Notes A and D) 843 635

Long-Term Debt (Note C) 21,059 16,975

Commitments (Note E)

Total liabilities 49,363 38,042

Stockholders’ Equity

Common stock, par value $1, authorized, 10,000,000 shares; issued, 4,803,000 shares in 2007 and 4,594,000 shares in 2006 (Note F) 4,803 4,594

Additional paid-in capital 957 910

Retained Earnings 40,175 32,363

Total stockholders’ equity 45,935 37,867

Total Liabilities and Stockholders’ Equity $95,298 $75,909

The accompanying notes are an integral part of these statements.

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meet demands for cash because the accounts receivable are of inferior quality or the inventory is salable only at discounted prices. It is necessary to use other measures of liquidity, including cash flow from operations and other financial ratios that rate the liquidity of specific assets, to supplement the current ratio.

Quick or Acid-Test Ratio

2007 2006 Current assets � Inventory 65,846 � 47,041 � .68 times 56,264 � 36,769 � .95 times

Current liabilities 27,461 20,432

The quick or acid-test ratio is a more rigorous test of short-run solvency than the cur- rent ratio because the numerator eliminates inventory, considered the least liquid current asset and the most likely source of losses. Like the current ratio and other ratios, there are alternative ways to calculate the quick ratio. Some analysts eliminate prepaid expenses and supplies (if carried as a separate item) from the numerator.The quick ratio for R.E.C. Inc. indicates some deterioration between 2006 and 2007; this ratio must also be examined in relation to the firm’s own trends and to other firms operating in the same industry.

Cash Flow Liquidity Ratio

2007 2006 Cash � Marketable securities � CFO* 4,061 � 5,272 � 10,024 � .70 times 2,382 � 8,004 � (3,767) � .32 times Current liabilities 27,461 20,432

*Cash flow from operating activities.

2007 2006 2005

Net sales $215,600 $153,000 $140,700

Cost of goods sold (Note A) 129,364 91,879 81,606

Gross profit 86,236 61,121 59,094

Selling and administrative expenses (Notes A and E) 45,722 33,493 32,765

Advertising 14,258 10,792 9,541

Depreciation and amortization (Note A) 3,998 2,984 2,501

Repairs and maintenance 3,015 2,046 3,031

Operating profit 19,243 11,806 11,256

Other income (expense)

Interest income 422 838 738

Interest expense (2,585) (2,277) (1,274)

Earnings before income taxes 17,080 10,367 10,720

Income taxes (Notes A and D) 7,686 4,457 4,824

Net earnings $ 9,394 $ 5,910 $ 5,896

Basic earnings per common share (Note G) $ 1.96 $ 1.29 $ 1.33

Diluted earnings per common share (Note G) $ 1.92 $ 1.26 $ 1.31

EXHIBIT 6.1 (Continued) R.E.C. Inc. Consolidated Statements of Earnings for the Years Ended December 31, 2007, 2006, and 2005 (in Thousands Except per Share Amounts)

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4For additional reading about this ratio and its applications, see Lyn Fraser, “Cash Flow from Operations and Liquidity Analysis, A New Financial Ratio for Commercial Lending Decisions,” Cash Flow, Robert Morris Associates, Philadelphia, PA. For other cash flow ratios, see C. Carslaw and J. Mills, “Developing Ratios for Effective Cash Flow Statement Analysis,” Journal of Accountancy, November 1991; D.E. Giacomino and D. E. Mielke, “Cash Flows: Another Approach to Ratio Analysis,” Journal of Accountancy, March 1993; and John R. Mills and Jeanne H. Yamamura, “The Power of Cash Flow Ratios,” Journal of Accountancy, October 1998.

Another approach to measuring short-term solvency is the cash flow liquidity ratio,4 which considers cash flow from operating activities (from the statement of cash flows). The cash flow liquidity ratio uses in the numerator, as an approximation of cash resources, cash and marketable securities, which are truly liquid current assets, and cash flow from operating activities, which represents the amount of cash generated from the firm’s operations, such as the ability to sell inventory and collect the cash.

Note that both the current ratio and the quick ratio decreased between 2006 and 2007, which could be interpreted as a deterioration of liquidity. But the cash flow ratio increased, indicating an improvement in short-run solvency. Which is the correct assess- ment? With any ratio, the analyst must explore the underlying components. One major reason for the decreases in the current and quick ratios was the 88% growth in accounts payable in 2007, which could actually be a plus if it means that R.E.C. Inc. strengthened its ability to obtain supplier credit. Also, the firm turned around from negative to posi- tive its generation of cash from operations in 2007, explaining the improvement in the cash flow liquidity ratio and indicating stronger short-term solvency.

Average Collection Period

2007 2006 Net accounts receivable 8,960 8,350

Average daily sales 215,600/365 � 15 days

153,000/365 � 20 days

The average collection period of accounts receivable is the average number of days required to convert receivables into cash. The ratio is calculated as the relation- ship between net accounts receivable (net of the allowance for doubtful accounts) and average daily sales (sales/365 days). Where available, the figure for credit sales can be substituted for net sales because credit sales produce the receivables. The ratio for R.E.C. Inc. indicates that during 2007 the firm collected its accounts in 15 days on average, which is an improvement over the 20-day collection period in 2006.

The average collection period helps gauge the liquidity of accounts receivable, the ability of the firm to collect from customers. It may also provide information about a company’s credit policies. For example, if the average collection period is increasing over time or is higher than the industry average, the firm’s credit policies could be too lenient and accounts receivables not sufficiently liquid. The loosening of credit could be neces- sary at times to boost sales, but at an increasing cost to the firm. On the other hand, if credit policies are too restrictive, as reflected in an average collection period that is short- ening and less than industry competitors, the firm may be losing qualified customers.

The average collection period should be compared with the firm’s stated credit policies. If the policy calls for collection within 30 days and the average collection period is 60 days, the implication is that the company is not stringent in collection

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efforts. There could be other explanations, however, such as temporary problems due to a depressed economy. The analyst should attempt to determine the cause of a ratio that is too long or too short.

Another factor for consideration is the strength of the firm within its industry.There are circumstances that would enable a company in a relatively strong financial position within its industry to extend credit for longer periods than weaker competitors.

Days Inventory Held

2007 2006 Inventory 47,041 36,769

Average daily cost of sales 129,364/365 � 133 days

91,879/365 � 146 days

The days inventory held is the average number of days it takes to sell inventory to customers. This ratio measures the efficiency of the firm in managing its inventory. Generally, a low number of days inventory held is a sign of efficient management; the faster inventory sells, the fewer funds tied up in inventory. On the other hand, too low a number could indicate understocking and lost orders, a decrease in prices, a shortage of materials, or more sales than planned. A high number of days inventory held could be the result of carrying too much inventory or stocking inventory that is obsolete, slow-moving, or inferior; however, there may be legitimate reasons to stockpile inven- tory, such as increased demand, expansion and opening of new retail stores, or an expected strike. R.E.C. Inc.’s days inventory held has decreased from 2006, an improvement over 2007.

The type of industry is important in assessing days inventory held. It is expected that florists and produce retailers would have a relatively low days inventory held because they deal in perishable products, whereas retailers of jewelry or farm equip- ment would have higher days inventory held, but higher profit margins. When making comparisons among firms, it is essential to check the cost flow assumption, discussed in Chapter 2, used to value inventory and cost of goods sold.

Days Payable Outstanding

2007 2006 Accounts payable 14,294 7,591

Average daily cost of sales 129,364/365 � 41 days

91,879/365 � 31 days

The days payable outstanding is the average number of days it takes to pay payables in cash. This ratio offers insight into a firm’s pattern of payments to suppliers. Delaying payment of payables as long as possible, but still making payment by the due date, is desirable. R.E.C. Inc. is taking longer to pay suppliers in 2007 compared to 2006.

Cash Conversion Cycle or Net Trade Cycle The cash conversion cycle or net trade cycle is the normal operating cycle of a firm that consists of buying or manufacturing inventory, with some purchases on credit and the creation of accounts payable; selling inventory, with some sales on credit and the

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creation of accounts receivable; and collecting the cash. The cash conversion cycle measures this process in number of days and is calculated as follows for R.E.C. Inc.:

2007 2006 Average collection period 15 days 20 days

plus Days inventory held 133 days 146 days

minus Days payable outstanding (41 days) (33 days)

equals Cash conversion or net trade cycle 107 days 133 days

The cash conversion cycle helps the analyst understand why cash flow generation has improved or deteriorated by analyzing the key balance sheet accounts—accounts receiv- able, inventory, and accounts payable—that affect cash flow from operating activities. R.E.C. Inc. has improved its cash conversion cycle by improving collection of accounts receivable, moving inventory faster, and taking longer to pay accounts payable. Despite this improvement, the firm has a mismatching of cash inflows and outflows since it takes 148 days to sell inventory and collect the cash, yet R.E.C. Inc.’s suppliers are being paid in 41 days. As mentioned previously, the company opened 43 new stores, and that is most likely the cause of the high level of inventory. In the future, R.E.C. Inc. should be able to improve further the days inventory held and the cash conversion cycle.

Activity Ratios: Asset Liquidity, Asset Management Efficiency Accounts Receivable Turnover

2007 2006 Net Sales 215,600

� 24.06 times 153,000

� 18.32 times Net accounts receivable 8,960 8,350

Inventory Turnover

2007 2006 Cost of goods sold 129,364

� 2.75 times 91, 879

� 2.50 times Inventory 47,041 36,769

Accounts Payable Turnover

2007 2006 Cost of goods sold 129,364

� 9.05 times 91,879

� 12.10 times Accounts payable 14,294 7,591

The accounts receivable, inventory, and payables turnover ratios measure how many times, on average, accounts receivable are collected in cash, inventory is sold, and payables are paid during the year. These three measures are mathematical complements to the ratios that make up the cash conversion cycle, and therefore, measure exactly what the

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average collection period, days inventory held, and days payable outstanding measure for a firm; they are merely an alternative way to look at the same information.

R.E.C. Inc. converted accounts receivable into cash 24 times in 2007, up from 18 times in 2006. Inventory turned over 2.75 times in 2007 compared to 2.5 times in 2006, meaning that inventory was selling slightly faster. The lower payables turnover indicates that the firm is taking longer to repay payables.

Fixed Asset Turnover

2007 2006 Net sales 215,600

� 7.41 times 153,000

� 8.06 times Net property, plant, equipment 29,079 18,977

Total Asset Turnover

2007 2006 Net sales 215,600

� 2.26 times 153,000

� 2.02 times Total assets 95,298 75,909

The fixed asset turnover and total asset turnover ratios are two approaches to assessing management’s effectiveness in generating sales from investments in assets. The fixed asset turnover considers only the firm’s investment in property, plant, and equipment and is extremely important for a capital-intensive firm, such as a manufac- turer with heavy investments in long-lived assets. The total asset turnover measures the efficiency of managing all of a firm’s assets. Generally, the higher these ratios, the smaller is the investment required to generate sales and thus the more profitable is the firm. When the asset turnover ratios are low relative to the industry or the firm’s historical record, either the investment in assets is too heavy and/or sales are sluggish. There may, however, be plausible explanations; for example, the firm may have under- taken an extensive plant modernization or placed assets in service at year-end, which will generate positive results in the long-term.

For R.E.C. Inc., the fixed asset turnover has slipped slightly, but the total asset turnover has improved. The firm’s investment in fixed assets has grown at a faster rate (53%) than sales (41%), and this occurrence should be examined within the frame- work of the overall analysis of R.E.C. Inc. The increase in total asset turnover is the result of improvements in inventory and accounts receivable turnover.

Leverage Ratios: Debt Financing and Coverage Debt Ratio

2007 2006 Total liabilities 49,363

� 51.8% 38,042

� 50.1% Total assets 95,298 75,909

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Long-Term Debt to Total Capitalization

2007 2006 Long-term debt 21,059 16,975

Long-term debt � Stockholders’ equity 21,059 � 45,935 � 31.4%

16,975 + 37,867 � 31.0%

Debt to Equity

2007 2006 Total liabilities 49,363

� 1.07 times 38,042

� 1.00 times Stockholders’ equity 45,935 37,867

Each of the three debt ratios measures the extent of the firm’s financing with debt. The amount and proportion of debt in a company’s capital structure is extremely important to the financial analyst because of the trade-off between risk and return. Use of debt involves risk because debt carries a fixed commitment in the form of interest charges and principal repayment. Failure to satisfy the fixed charges associated with debt will ultimately result in bankruptcy. A lesser risk is that a firm with too much debt has difficulty obtaining additional debt financing when needed or finds that credit is available only at extremely high rates of interest. Although debt implies risk, it also introduces the potential for increased benefits to the firm’s owners. When debt is used successfully—if operating earnings are more than suf- ficient to cover the fixed charges associated with debt—the returns to shareholders are magnified through financial leverage, a concept that is explained and illustrated later in this chapter.

The debt ratio considers the proportion of all assets that are financed with debt. The ratio of long-term debt to total capitalization reveals the extent to which long- term debt is used for the firm’s permanent financing (both long-term debt and equity). The debt-to-equity ratio measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity). The higher the proportion of debt, the greater is the degree of risk because creditors must be satisfied before owners in the event of bankruptcy. The equity base provides, in effect, a cushion of protection for the suppliers of debt. Each of the three ratios has increased somewhat for R.E.C. Inc. between 2007 and 2006, implying a slightly riskier capital structure.

The analyst should be aware that the debt ratios do not present the whole pic- ture with regard to risk. There are fixed commitments, such as lease payments, that are similar to debt but are not included in debt. The fixed charge coverage ratio, illustrated later, considers such obligations. Off-balance-sheet financing arrange- ments, discussed in Chapter 1, also have the characteristics of debt and must be dis- closed in notes to the financial statements according to the provisions of FASB Statement No. 105. These arrangements should be included in an evaluation of a firm’s overall capital structure.

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5The amounts for interest and taxes paid are found in the supplemental disclosures on the statement of cash flows.

6The operating return, operating profit divided by assets, must exceed the cost of debt, interest expense divided by liabilities.

Times Interest Earned

2007 2006 Operating profit 19,243

� 7.4 times 11,806

� 5.2 times Interest expense 2,585 2,277

Cash Interest Coverage

2007 2006 CFO � interest paid � taxes paid5 10,024 � 2,585 � 7,478

� 7.77 times (3,767)�2,277�4,321

� 1.24 times Interest paid 2,585 2,277

In order for a firm to benefit from debt financing, the fixed interest payments that accompany debt must be more than satisfied from operating earnings.6 The higher the times interest earned ratio the better; however, if a company is generating high profits, but no cash flow from operations, this ratio is misleading. It takes cash to make interest payments! The cash interest coverage ratio measures how many times interest pay- ments can be covered by cash flow from operations before interest and taxes.Although R.E.C. Inc. increased its use of debt in 2007, the company also improved its ability to cover interest payments from operating profits and cash from operations. Note that in 2006, the firm could cover interest payments only 1.24 times due to the poor cash generated from operations before interest and taxes. The times interest earned ratio in 2006 is somewhat misleading in this instance.

Fixed Charge Coverage

2007 2006 Operating profit � Rent expense* 19,243 � 13,058

� 2.1 times 11,806 � 7,111

� 2.0 times Interest expense � Rent expense* 2,585 � 13,058 2,277 � 7,111

*Rent expense � operating lease payments

The fixed charge coverage ratio is a broader measure of coverage capability than the times interest earned ratio because it includes the fixed payments associated with leasing. Operating lease payments, generally referred to as rent expense in annual reports, are added back in the numerator because they were deducted as an operating expense to calculate operating profit. Operating lease payments are similar in nature to interest expense in that they both represent obligations that must be met on an annual basis. The fixed charge coverage ratio is important for firms that operate exten- sively with operating leases. R.E.C. Inc. experienced a significant increase in the amount of annual lease payments in 2007 but was still able to improve its fixed charge coverage slightly.

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Cash Flow Adequacy

2007 2006 Cash flow from operating activities 10,024 (3,767)

Capital expenditures � debt repayments 14,100 � 30 �1,516 4,773 � 1,593 � dividends paid � 1,582 � 0.58 times � 1,862 � (0.46) times

Credit rating agencies often use cash flow adequacy ratios to evaluate how well a com- pany can cover annual payments of items such as debt, capital expenditures, and dividends from operating cash flow. Cash flow adequacy is generally defined differently by analysts; therefore, it is important to understand what is actually being measured. Cash flow ade- quacy is being used here to measure a firm’s ability to cover capital expenditures, debt maturities, and dividend payments each year. Companies over the long run should gener- ate enough cash flow from operations to cover investing and financing activities of the firm. If purchases of fixed assets are financed with debt, the company should be capable of covering the principal payments with cash generated by the company.A larger ratio would be expected if the company pays dividends annually because cash used for dividends should be generated internally by the company, rather than by borrowing.As indicated in Chapter 4, companies must generate cash to be successful. Borrowing each year to pay div- idends and repay debt is a questionable cycle for a company to be in over the long run.

In 2007, R.E.C. Inc. had a cash flow adequacy ratio of .58 times, an improvement over 2006 when the firm failed to generate cash from operations.

Profitability Ratios: Overall Efficiency and Performance Gross Profit Margin

2007 2006 Gross profit 86,236 61,121

Net sales 215,600 � 40.0%

153,000 � 39.9%

Operating Profit Margin

2007 2006 Operating profit 19,243 11,806

Net sales 215,600 � 8.9%

153,000 � 7.7%

Net Profit Margin

2007 2006 Net earnings 9,394 5,910

Net sales 215,600 = 4.4%

153,000 � 3.9%

Gross profit margin, operating profit margin, and net profit margin represent the firm’s ability to translate sales dollars into profits at different stages of measurement.

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The gross profit margin, which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers. The operating profit margin, a measure of overall operating efficiency, incorporates all of the expenses associated with ordinary business activities. The net profit margin measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items.

There was little change in the R.E.C. Inc. gross profit margin, but the company improved its operating margin. Apparently, the firm was able to control the growth of operating expenses while sharply increasing sales. There was also a slight increase in net profit margin, a flow-through from operating margin, but it will be necessary to look at these ratios over a longer term and in conjunction with other parts of the analy- sis to explain the changes.

Cash Flow Margin

2007 2006 Cash flow from operating activities 10,024 (3,767)

Net sales 215,600 � 4.6%

153,000 � (2.5%)

Another important perspective on operating performance is the relationship between cash generated from operations and sales. As pointed out in Chapter 4, it is cash, not accrual-measured earnings, that a firm needs to service debt, pay dividends, and invest in new capital assets. The cash flow margin measures the ability of the firm to translate sales into cash.

In 2007, R.E.C. Inc. had a cash flow margin that was greater than its net profit margin, the result of a strongly positive generation of cash. The performance in 2007 represents a solid improvement over 2006 when the firm failed to generate cash from operations and had a negative cash flow margin.

Return on Total Assets (ROA) or Return on Investment (ROI)

2007 2006 Net earnings 9,394 5,910 Total assets 95,298

� 9.9% 75,909

� 7.8%

Return on Equity (ROE)

2007 2006 Net earnings 9,394 5,910

Stockholders’ equity 45,935 � 20.5%

37,867 � 15.6%

Return on investment and return on equity are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders. Return on investment or return on assets indicates the amount of

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profit earned relative to the level of investment in total assets. Return on equity measures the return to common shareholders; this ratio is also calculated as return on common equity if a firm has preferred stock outstanding. R.E.C. Inc. registered a solid improvement in 2004 of both return ratios.

Cash Return on Assets

2007 2006 Cash flow from operating activities 10,024 (3,767)

Total assets 95,298 � 10.5%

75,909 � (5.0%)

The cash return on assets offers a useful comparison to return on investment. Again, the relationship between cash generated from operations and an accrual-based number allows the analyst to measure the firm’s cash generating ability of assets. Cash will be required for future investments.

Market Ratios Four market ratios of particular interest to the investor are earnings per common share, the price-to-earnings ratio, the dividend payout ratio, and dividend yield. Despite the accounting scandals, including Enron and WorldCom, that illustrated the flaws in the earnings numbers presented to the public, investors continue to accept and rely on the earnings per share and price-to-earnings ratios. A discussion of these ratios is included since the reporting of these numbers does, in fact, have a significant impact on stock price changes in the marketplace. The authors hope, however, that readers of this book understand that a thorough analysis of the com- pany, its environment, and its financial information offers a much better gauge to the future prospects of the company than looking exclusively at earnings per share and price-to-earnings ratios. These two ratios are based on an earnings number that can be misleading at times due to the many accounting choices and techniques used to calculate it.

Earnings per common share is net income for the period divided by the weighted average number of common shares outstanding. One million dollars in earnings will look different to the investor if there are 1 million shares of stock outstanding or 100,000 shares. The earnings per share ratio provides the investor with a common denominator to gauge investment returns.

The basic earnings per share computations for R.E.C. Inc. are made as follows:

2007 2006 2005 Net earnings 9,394,000 5,910,000 5,896,000

Average shares outstanding 4,792,857 � 1.96

4,581,395 � 1.29

4,433,083 � 1.33

Earnings per share figures must be disclosed on the face of the income statement for publicly held companies.

The price-to-earnings ratio (P/E ratio) relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market

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FIGURE 6.1 Summary of Financial Ratios

7Using diluted earnings per share in market ratios offers a worst-case scenario figure that analysts may find useful.

Current Ratio

Average Collection

Period Debt/Assets

Times Interest Earned

Accounts Receivable Turnover

Gross Profit

Margin

Return on Total Assets

Quick Ratio Days

Inventory Held

Debt/Equity

Fixed Charge

Coverage

Inventory Turnover

Operating Profit

Margin

Return on Equity

Cash Flow Liquidity

Ratio

Cash Flow Adequacy

Fixed Asset Turnover

Net Profit Margin

Cash Return on Assets

Price/ Earnings

Total Asset Turnover

Cash Flow Margin

Dividend Payout

Dividend Yield

Financial Leverage

Index

Return on Total Assets

Long-Term Debt

Total Capitalization

Days Payable

Outstanding

Cash Conversion

Cycle

Accounts Payable Turnover

Short Run Solvency

Liquidity of Current

Assets

Amount of Debt

Coverage of Debt

Operating Efficiency

Margins Returns

Cash Interest

Coverage

Earnings per Share

Liquidity Leverage

Asset Management

Profitability Market

Measures

Summary of Financial Statement Analysis How to Use Financial Ratios

places on a firm’s earnings. For instance, if two competing firms had annual earnings of $2.00 per share, and Company 1 shares sold for $10.00 each and Company 2 shares were selling at $20.00 each, the market is placing a different value on the same $2.00 earnings: a multiple of 5 for Company 1 and 10 for Company 2. The P/E ratio is the function of a myriad of factors, which include the quality of earnings, future earnings potential, and the performance history of the company.7

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The price-to-earnings ratio for R.E.C. Inc. would be determined as follows:

2007 2006 2005 Market price of common stock 30.00

� 15.3 17.00

� 13.2 25.00

� 18.8 Earnings per share 1.96 1.29 1.33

The P/E ratio is higher in 2007 than 2006 but below the 2005 level. This could be due to developments in the market generally and/or because the market is reacting cautiously to the firm’s good year.Another factor could be the reduction of cash dividend payments.

The dividend payout ratio is determined by the formula cash dividends per share divided by earnings per share:

2007 2006 2005 Dividends per share .33 .41 .41 Earnings per share 1.96

� 16.8% 1.29

� 31.8% 1.33

� 30.8%

R.E.C. Inc. reduced its cash dividend payment in 2007. It is unusual for a company to reduce cash dividends because this decision can be read as a negative signal regard- ing the future outlook. It is particularly uncommon for a firm to reduce dividends dur- ing a good year.The explanation provided by management is that the firm has adopted a new policy that will result in lower dividend payments in order to increase the avail- ability of internal funds for expansion; management expects the overall long-term impact to be extremely favorable to shareholders and has committed to maintaining the $.33 per share annual cash dividend.

The dividend yield shows the relationship between cash dividends and market price:

2007 2006 2005 Dividends per share .33 .41 .41

Market price of common stock 30.00 � 1.1%

17.00 � 2.4%

25.00 � 1.6%

The R.E.C. Inc. shares are yielding a 1.1% return based on the market price at year-end 2007; an investor would likely choose R.E.C. Inc. as an investment more for its long-term capital appreciation than for its dividend yield.

Figure 6.1 shows in summary form the use of key financial ratios discussed in the chapter.

Analyzing the Data Would you as a bank loan officer extend $1.5 million in new credit to R.E.C. Inc.? Would you as an investor purchase R.E.C. Inc. common shares at the current market price of $30 per share? Would you as a wholesaler of running shoes sell your products on credit to R.E.C. Inc.? Would you as a recent college graduate accept a position as manager-trainee with R.E.C. Inc.? Would you as the chief financial officer of R.E.C. Inc. authorize the opening of 25 new retail stores during the next two years?

In order to answer such questions, it is necessary to complete the analysis of R.E.C. Inc.’s financial statements, utilizing the common-size financial statements and key finan- cial ratios as well as other information presented throughout the book. Ordinarily, the analysis would deal with only one of the above questions, and the perspective of the

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212 CHAPTER 6 The Analysis of Financial Statements

8The background section of R.E.C. Inc. is based on an unpublished paper by Kimberly Ann Davis, “A Financial Analysis of Oshman’s Sporting Goods, Inc.”

FIGURE 6.2 Steps of a Financial Statement Analysis

1. Establish objectives of the analysis. 2. Study the industry in which firm operates and relate industry climate to current and

projected economic developments. 3. Develop knowledge of the firm and the quality of management. 4. Evaluate financial statements.

• Tools: Common size financial statements, key financial ratios, trend analysis, structural analysis, and comparison with industry competitors.

• Major Areas: Short-term liquidity, operating efficiency, capital structure and long-term solvency, profitability, market ratios, segmental analysis (when rele- vant), and quality of financial reporting.

5. Summarize findings based on analysis and reach conclusions about firm relevant to the established objectives.

financial statement user would determine the focus of the analysis. Because the purpose of this chapter is to present a general approach to financial statement analysis, however, the evaluation will cover each of five broad areas that would typically constitute a fundamental analysis of financial statements: (1) background on firm, industry, economy, and outlook; (2) short-term liquidity; (3) operating efficiency; (4) capital structure and long-term solvency; and (5) profitability. From this general approach, each analytical situation can be tailored to meet specific user objectives.

Figure 6.2 shows the steps of a financial statement analysis.

Background: Economy, Industry, and Firm An individual company does not operate in a vacuum. Economic developments and the actions of competitors affect the ability of any business enterprise to perform suc- cessfully. It is therefore necessary to preface the analysis of a firm’s financial state- ments with an evaluation of the environment in which the firm conducts business. This process involves blending hard facts with guesses and estimates. Reference to the section entitled “Other Sources” in this chapter may be beneficial for this part of the analysis. A brief section discussing the business climate of R.E.C. Inc. follows.8

Recreational Equipment and Clothing Incorporated (R.E.C. Inc.) is the third largest retailer of recreational products in the United States. The firm offers a broad line of sporting goods and equipment and active sports apparel in medium to higher price ranges. R.E.C. Inc. sells equipment used in running, aerobics, walking, basketball, golf, tennis, skiing, football, scuba diving, and other sports; merchandise for camping, hiking, fishing, and hunting; men’s and women’s sporting apparel; gift items; games; and consumer electronic products. The firm also sells sporting goods on a direct basis to institutional customers such as schools and athletic teams.

The general and executive offices of the company are located in Dime Box, Texas, and these facilities were expanded in 2007. Most of the retail stores occupy leased

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spaces and are located in major regional or suburban shopping districts throughout the southwestern United States. Eighteen new retail outlets were added in late 2006, and 25 new stores were opened in 2007. The firm owns distribution center warehouses located in Arizona, California, Colorado, Utah, and Texas.

The recreational products industry is affected by current trends in consumer pref- erences, a cyclical sales demand, and weather conditions.The running boom has shifted to walking and aerobics; golf, once on the downswing, is increasing in popularity; with multiple wins in the Tour de France, American Lance Armstrong invigorated the cycling industry in the United States. Recreational product retailers also rely heavily on sales of sportswear for their profits, because the markup on sportswear is generally higher than on sports equipment, and these products are also affected by consumer preference shifts. With regard to seasonality, most retail sales occur in November, December, May, and June. Sales to institutions are highest in August and September. Weather conditions also influence sales volume, especially of winter sports equip- ment—come on, Rocky Mountain snow!

Competition within the recreational products industry is based on price, quality, and variety of goods offered as well as the location of outlets and the quality of services offered. R.E.C. Inc.’s two major competitors are also full-line sporting goods compa- nies. One operates in the northwest and the other primarily in the eastern and south- eastern United States, reducing direct competition among the three firms.

The current outlook for the sporting goods industry is promising, following a reces- sionary year in 2006.9 Americans have become increasingly aware of the importance of physical fitness and have become more actively involved in recreational activities. The 25-to-44 age group is the most athletically active and is projected to be the largest age group in the United States during the next decade. The southwestern United States is expected to provide a rapidly expanding market because of its population growth and excellent weather conditions for year-round recreational participation.

Short-Term Liquidity Short-term liquidity analysis is especially important to creditors, suppliers, manage- ment, and others who are concerned with the ability of a firm to meet near-term demands for cash. The evaluation of R.E.C. Inc.’s short-term liquidity position began with the preparation and interpretation of the firm’s common-size balance sheet earlier in the chapter. From that assessment, it was evident that inventories have increased relative to cash and marketable securities in the current asset section, and there has been an increase in the proportion of debt, both short and long term. These developments were traced primarily to policies and financing needs related to new store openings. Additional evidence useful to short-term liquidity analysis is provided by a five-year trend of selected financial ratios and a comparison with industry averages. Sources of comparative industry ratios include Dun & Bradstreet, Industry Norms and Key Business Ratios, New York, NY; The Risk Management Association, Annual Statement Studies, Philadelphia, PA; and Standard & Poor’s Corporation, Industry Surveys, New York, NY.As a source of industry comparative ratios, the analyst may prefer to develop a set of financial ratios for one or more major competitors.

9The recession is assumed for purposes of writing this book and does not represent the authors’ forecast.

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214 CHAPTER 6 The Analysis of Financial Statements

Industry Average

R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Current ratio 2.40 2.75 2.26 2.18 2.83 2.53 Quick ratio .68 .95 .87 1.22 1.20 .97 Cash flow liquidity .70 .32 .85 .78 .68 * Average collection period 15 days 20 days 13 days 11 days 10 days 17 days Days inventory held 133 days 146 days 134 days 122 days 114 days 117 days Days payable outstanding 41 days 33 days 37 days 34 days 35 days 32 days Cash conversion cycle 107 days 133 days 110 days 99 days 89 days 102 days Cash flow from operating

activities ($ thousands) 10,024 (3,767) 5,629 4,925 3,430 *

*Not available

Liquidity analysis involves the prediction of the future ability of the firm to meet pro- spective needs for cash.This prediction is made from the historical record of the firm, and no one financial ratio or set of financial ratios or other financial data can serve as a proxy for future developments. For R.E.C. Inc., the financial ratios are somewhat contradictory.

The current and quick ratios have trended downward over the five-year period, indi- cating a deterioration of short-term liquidity. On the other hand, the cash flow liquidity ratio improved strongly in 2007 after a year of negative cash generation in 2006.The aver- age collection period for accounts receivable and the days inventory held ratio—after worsening between 2003 and 2006—also improved in 2007.These ratios measure the qual- ity or liquidity of accounts receivable and inventory. The average collection period increased to a high of 20 days in 2006, which was a recessionary year in the economy, then decreased to a more acceptable 15-day level in 2007. Days payable outstanding has varied each year, but has increased overall from 2003 to 2007.As long as the company is not late paying bills, this should not be a significant problem. The net trade cycle worsened from 2003 to 2006 due to an increasing collection period and longer number of days inventory was held. In 2007, a significant improvement in management of current assets and liabili- ties has caused the cash conversion cycle to drop by 26 days from the high of 133 days in 2006. It is now much closer to the industry average.

The common-size balance sheet for R.E.C. Inc. revealed that inventories now comprise about half of the firm’s total assets.The growth in inventories has been necessary to satisfy the requirements associated with the opening of new retail outlets but has been accomplished by reducing holdings of cash and cash equivalents. This represents a trade- off of highly liquid assets for potentially less liquid assets. The efficient management of inventories is a critical ingredient for the firm’s ongoing liquidity. In 2007, days inventory held improved in spite of the buildups necessary to stock new stores. Sales demand in 2007 was more than adequate to absorb the 28% increase in inventories recorded for the year.

The major question in the outlook for liquidity is the ability of the firm to produce cash from operations. Problems in 2006 resulted partly from the depressed state of the economy and poor ski conditions, which reduced sales growth. The easing of sales demand hit the company in a year that marked the beginning of a major market expansion. Inventories and receivables increased too fast for the limited sales growth of a recessionary year, and R.E.C. also experienced some reduction of credit availability from suppliers that felt the economic pinch. The con- sequence was a cash crunch and negative cash flow from operations.

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In 2007, R.E.C. Inc. enjoyed considerable improvement, generating more than $10 million in cash from operations and progress in managing inventories and receivables. There appears to be no major problem with the firm’s short-term liquidity position at the present time. Another poor year, however, might well cause problems similar to those experienced in 2006. The timing of further expansion of retail outlets will be of critical importance to the ongoing success of the firm.

Operating Efficiency

Industry Average

R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Accounts receivable

turnover 24.06 18.32 28.08 33.18 36.50 21.47 Inventory

turnover 2.75 2.50 2.74 2.99 3.20 3.12 Accounts payable

turnover 9.05 12.10 9.90 10.74 10.43 11.40 Fixed asset turnover 7.41 8.06 8.19 10.01 10.11 8.72 Total asset turnover 2.26 2.02 2.13 2.87 2.95 2.43

The turnover ratios measure the operating efficiency of the firm. The efficiency in managing the company’s accounts receivable, inventory, and accounts payable was discussed in the short-term liquidity analysis. R.E.C. Inc.’s fixed asset turnover has decreased over the past five years and is now below the industry average. As noted earlier, R.E.C. Inc. has increased its investment in fixed assets as a result of home office and store expansion. The asset turnover ratios reveal a downward trend in the efficiency with which the firm is generating sales from investments in fixed and total assets. The total asset turnover rose in 2007, progress traceable to improved management of inventories and receivables. The fixed asset turnover ratio is still declining, a result of expanding offices and retail outlets, but should improve if the expansion is successful.

Capital Structure and Long-Term Solvency The analytical process includes an evaluation of the amount and proportion of debt in a firm’s capital structure as well as the ability to service debt. Debt implies risk because debt involves the satisfaction of fixed financial obligations. The disadvantage of debt financing is that the fixed commitments must be met in order for the firm to continue operations. The major advantage of debt financing is that, when used successfully, shareholder returns are magnified through financial leverage. The concept of financial leverage can best be illustrated with an example (Figure 6.3).

Industry Average

R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Debt to total assets 51.8% 50.1% 49.2% 40.8% 39.7% 48.7% Long-term debt to

total capitalization 31.4% 31.0% 24.1% 19.6% 19.8% 30.4% Debt to equity 1.07 1.00 .96 .68 .66 .98

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216 CHAPTER 6 The Analysis of Financial Statements

FIGURE 6.3 Example of Financial Leverage

Sockee Sock Company has $100,000 in total assets, and the firm’s capital structure consists of 50% debt and 50% equity:

Debt $ 50.000 Equity 50.000 Total assets $100.000

Cost of debt � 10% Average tax rate � 40%

If Sockee has $20,000 in operating earnings, the return to shareholders as measured by the return on equity ratio would be 18%:

Operating earnings $20.000 Interest expense 5.000 Earnings before tax 15.000 Tax expense 6.000 Net earnings $ 9.000

Return on equity: 9,000/50,000 � 18%

If Sockee is able to double operating earnings from $20,000 to $40,000, the return on equity will more than double, increasing from 18% to 42%:

Operating earnings $40.000 Interest expense 5.000 Earnings before tax 35.000 Tax expense 14.000 Net earnings $21.000

Return on equity: 21.000/50.000 � 42%

The magnified return on equity results from financial leverage. Unfortunately, leverage has a double edge. If operating earnings are cut in half from $20,000 to $10,000, the return on equity is more than halved, declining from 18% to 6%:

Operating earnings $10.000 Interest expense 5.000 Earnings before tax 5.000 Tax expense 2.000 Net earnings $ 3.000

Return on equity: 3.000/50.000 � 6%

The amount of interest expense is fixed, regardless of the level of operating earnings. When operating earnings rise or fall, financial leverage produces positive or negative effects on shareholder returns. In evaluating a firm’s capital structure and solvency, the analyst must constantly weigh the potential benefits of debt against the risks inherent in its use.

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The debt ratios for R.E.C. Inc. reveal a steady increase in the use of borrowed funds. Total debt has risen relative to total assets, long-term debt has increased as a proportion of the firm’s permanent financing, and external or debt financing has increased relative to internal financing. Given the greater degree of risk implied by borrowing, it is important to determine (1) why debt has increased; (2) whether the firm is employing debt successfully; and (3) how well the firm is covering its fixed charges.

Why has debt increased? The Summary Statement of Cash Flows, discussed in Chapter 4 and repeated here as Exhibit 6.2, provides an explanation of borrowing cause. Exhibit 6.2 shows the inflows and outflows of cash both in dollar amounts and percentages.

Exhibit 6.2 shows that R.E.C. Inc. has substantially increased its investment in capital assets, particularly in 2007 when additions to property, plant, and equipment accounted for 82% of the total cash outflows. These investments have been financed largely by borrowing, especially in 2006 when the firm had a sluggish operating performance and no internal cash generation. Operations supplied 73% of R.E.C. Inc.’s cash in 2005 and 62% in 2007, but the firm had to borrow heavily in 2006 (98% of cash inflows). The impact of this borrowing is seen in the firm’s debt ratios.

How effectively is R.E.C. Inc. using financial leverage? The answer is determined by calculating the financial leverage index (FLI), as follows:

Return on equity Adjusted return on assets

� Finanacial leverage index

EXHIBIT 6.2 R.E.C. Inc. Summary Analysis Statement of Cash Flows (in Thousands)

2007 % 2006 % 2005 %

Inflows (thousands)

Operations $10,024 62.0 $ 0 0.0 $5,629 73.0

Sales of other assets 295 1.8 0 0.0 0 0.0

Sales of common stock 256 1.6 183 1.8 124 1.6

Additions of short-term debt 0 0.0 1,854 18.7 1,326 17.2

Additions of long-term debt 5,600 34.6 7,882 79.5 629 8.2

Total $16,175 100.0 $ 9,919 100.0 $7,708 100.0

Outflows (thousands)

Operations $ 0 0.0 $ 3,767 31.4 $ 0 0.0

Purchase of property, plant,and equipment 14,100 81.8 4,773 40.0 3,982 66.9

Reductions of short-term debt 30 0.2 0 0.0 0 0.0

Reductions of long-term debt 1,516 8.8 1,593 13.2 127 2.1

Dividends paid 1,582 9.2 1,862 15.4 1,841 31.0

Total $17,228 100.0 $11,995 100.0 $5,950 100.0

Change in cash and marketable securities ($ 1,053) ($2,076) $1,758

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The adjusted return on assets in the denominator of this ratio is calculated as follows:

Net earnings � interest expense (1�tax rate)10

Total assets

When the FLI is greater than 1, which indicates that return on equity exceeds return on assets, the firm is employing debt beneficially. An FLI of less than 1 means the firm is not using debt successfully. For R.E.C. Inc., the adjusted return on assets and FLI are calculated as follows:

2007 2006 2005 Net earnings � interest expense (1 � tax rate) 9,394 � 2,585(1 � .45) 5,910 � 2,277(1�.43) 5,896 � 1,274(1�.45)

Total assets 95,298 75,909 66,146

2007 2006 2005 Return on equity 20.45

� 1.8 15.61

� 1.6 17.53

� 1.8 Adjusted return on assets 11.35 9.50 9.97

The FLI for R.E.C. Inc. of 1.8 in 2007, 1.6 in 2006, and 1.8 in 2005 indicates a suc- cessful use of financial leverage for the three-year period when borrowing has increased. The firm has generated sufficient operating returns to more than cover the interest payments on borrowed funds.

How well is R.E.C. Inc. covering fixed charges? The answer requires a review of the coverage ratios.

Industry Average

R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Times interest earned 7.44 5.18 8.84 13.34 12.60 7.2 Cash interest coverage 7.77 1.24 9.11 11.21 11.90 * Fixed charge coverage 2.09 2.01 2.27 2.98 3.07 2.5 Cash flow adequacy 0.58 (0.46) 0.95 1.03 1.24 *

* Not available

Given the increased level of borrowing, the times interest earned and cash inter- est coverage ratios have declined over the five-year period but times interest earned remains above the industry average. Cash interest coverage indicates that R.E.C. Inc. is generating enough cash to actually make the cash payments. R.E.C. Inc. leases the majority of its retail outlets so the fixed charge coverage ratio, which considers lease payments as well as interest expense, is a more relevant ratio than times interest earned. This ratio has also decreased, as a result of store expansion and higher payments for leases and interest. Although below the industry average, the firm is still

218 CHAPTER 6 The Analysis of Financial Statements

10The effective tax rate to be used in this ratio was calculated in Chapter 3.

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covering all fixed charges by more than two times out of operating earnings, and coverage does not at this point appear to be a problem. The fixed charge coverage ratio is a ratio to be monitored closely in the future, however, particularly if R.E.C. Inc. continues to expand. The cash flow adequacy ratio has dropped below 1.0 in 2005, 2006, and 2007 indicating the company does not generate enough cash from opera- tions to cover capital expenditures, debt repayments, and cash dividends. To improve this ratio, the firm needs to begin reducing accounts receivables and inventories, thereby increasing cash from operations. Once the expansion is complete this should occur, however, if the expansion continues, cash flow adequacy will likely remain below 1.0.

Profitability The analysis now turns to a consideration of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios.

Industry Average

R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Gross profit margin 40.00% 39.95% 42.00% 41.80% 41.76% 37.25% Operating profit margin 8.93% 7.72% 8.00% 10.98% 11.63% 7.07% Net profit margin 4.36% 3.86% 4.19% 5.00% 5.20% 3.74% Cash flow margin 4.65% (2.46)% 4.00% 4.39% 3.92% *

* Not available

Profitability—after a relatively poor year in 2006 due to economic recession, adverse ski conditions, and the costs of new store openings—now looks more promis- ing. Management adopted a growth strategy reflected in aggressive marketing and the opening of 18 new stores in 2006 and 25 in 2007. With the exception of the cash flow margin, the profit margins are all below their 2003 and 2004 levels but have improved in 2007 and are above industry averages. The cash flow margin, as a result of strong cash generation from operations in 2007, was at its highest level of the five- year period.

The gross profit margin was stable, a positive sign in light of new store openings featuring many “sale” and discounted items to attract customers, and the firm managed to improve its operating profit margin in 2007. The increase in operating profit margin is especially noteworthy because it occurred during an expansionary period with sizable increases in operating expenses, especially lease payments required for new stores. The net profit margin also improved in spite of increased interest and tax expenses and a reduction in interest revenue from marketable secu- rity investments.

Average R.E.C. Inc. 2007 2006 2005 2004 2003 2007 Return on assets 9.86% 7.79% 8.91% 14.35% 15.34% 9.09% Return on equity 20.45% 15.61% 17.53% 24.25% 25.46% 17.72% Cash return on assets 10.52% (4.96)% 8.64% 15.01% 15.98% *

* Not available

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220 CHAPTER 6 The Analysis of Financial Statements

After declining steadily through 2006, return on assets, return on equity, and cash return on assets rebounded strongly in 2007. The return on assets and return on equity ratios measure the overall success of the firm in generating profits, whereas the cash return on assets measures the firm’s ability to generate cash from its invest- ment and management strategies. It would appear that R.E.C. Inc. is well positioned for future growth. As discussed earlier, it will be important to monitor the firm’s management of inventories, which account for half of total assets and have been problematic in the past. The expansion will necessitate a continuation of expendi- tures for advertising, at least at the current level, in order to attract customers to both new and old areas. R.E.C. Inc. has financed much of its expansion with debt, and thus far its shareholders have benefited from the use of debt through financial leverage.

R.E.C. Inc. experienced a negative cash flow from operations in 2006, another problem that bears watching in the future. The negative cash flow occurred in a year of only modest sales and earnings growth:

R.E.C. Inc. 2007 2006 2005 2004 2003 Sales growth 40.9% 8.7% 25.5% 21.6% 27.5% Earnings growth 59.0% .2% 5.2% 16.9% 19.2%

Sales expanded rapidly in 2007 as the economy recovered and the expansion of retail outlets began to pay off. The outlook is for continued economic recovery.

Relating the Ratios—The Du Pont System Having looked at individual financial ratios as well as groups of financial ratios mea- suring short-term liquidity, operating efficiency, capital structure and long-term sol- vency, and profitability, it is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios. That is, how do the various pieces of financial measurement work together to produce an overall return? The Du Pont Sys- tem helps the analyst see how the firm’s decisions and activities over the course of an accounting period—which is what financial ratios are measuring—interact to produce an overall return to the firm’s shareholders, the return on equity. The summary ratios used are the following:

(1) (2) (3) Net profit margin � Total asset turnover � Return on investment

Net income �

Net sales �

Net income

Net sales Total assets Total assets

(3) (4) (5) Return on investment � Financial leverage � Return on equity

Net income �

Total assets �

Net income

Total assets Stockholders’ equity Stockholders’ equity

By reviewing this series of relationships, the analyst can identify strengths and weaknesses as well as trace potential causes of any problems in the overall financial condition and performance of the firm.

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The first three ratios reveal that the (3) return on investment (profit generated from the overall investment in assets) is a product of the (1) net profit margin (profit generated from sales) and the (2) total asset turnover (the firm’s ability to produce sales from its assets). Extending the analysis, the remaining three ratios show how the (5) return on equity (overall return to shareholders, the firm’s owners) is derived from the product of (3) return on investment and (4) financial leverage (proportion of debt in the capital structure). Using this system, the analyst can evaluate changes in the firm’s condition and performance, whether they are indicative of improvement or deterioration or some combination. The evaluation can then focus on specific areas contributing to the changes.

Evaluating R.E.C. Inc. using the Du Pont System over the five-year period 2003 to 2007 would show the following relationships:

Du Pont System applied to R.E.C. Inc. (1) (2) (3) (4) (5)

NPM × TAT � ROI × FL � ROE 2003 5.20 × 2.95 � 15.34 × 1.66 � 25.46 2004 5.00 × 2.87 � 14.35 × 1.69 � 24.25 2005 4.19 × 2.13 � 8.92 × 1.97 � 17.57 2006 3.86 × 2.02 � 7.80 × 2.00 � 15.60 2007 4.36 × 2.26 � 9.85 × 2.07 � 20.39

As discussed earlier in the chapter, return on equity is below earlier year levels but has improved since its low point in 2006. The Du Pont System helps provide clues as to why these changes have occurred. Both the profit margin and the asset turnover are lower in 2007 than in 2003 and 2004. The combination of increased debt (financial leverage) and the improvement in profitability and asset utilization has produced an improved overall return in 2007 relative to the two previous years. Specifically, the firm has added debt to finance capital asset expansion and has used its debt effectively. Although debt carries risk and added cost in the form of interest expense, debt has the positive benefit of financial leverage when debt is employed successfully, which is the case for R.E.C. Inc.The 2007 improvement in inventory management has impacted the firm favorably, showing up in the improved total asset turnover ratio. The firm’s ability to control operating costs while increasing sales during expansion has improved the net profit margin. The overall return on investment is now improving as a result of these combined factors.

Projections and Pro Forma Statements Some additional analytical tools and financial ratios are relevant to financial statement analysis, particularly for investment decisions and long-range planning. Although an in-depth discussion of these tools is beyond the scope of this chapter, we provide an introductory treatment of projections, pro forma financial statements, and several investment-related financial ratios.

The investment analyst, in valuing securities for investment decisions, must project the future earnings stream of a business enterprise. References that provide earnings forecasts are found in the “Other Sources” section earlier in the chapter.

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222 CHAPTER 6 The Analysis of Financial Statements

Pro forma financial statements are projections of financial statements based on a set of assumptions regarding future revenues, expenses, level of investment in assets, financing methods and costs, and working capital management. Pro forma financial statements are utilized primarily for long-range planning and long-term credit decisions. A bank considering the extension of $1.5 million in new credit to R.E.C. Inc. would want to look at the firm’s pro forma statements, assuming the loan is granted, and determine—using different scenarios regarding the firm’s performance—whether cash flow from operations would be sufficient to service the debt. R.E.C. Inc.’s CEO, who is making a decision about new store expansion, would develop pro forma state- ments based on varying estimates of performance outcomes and financing alternatives.

It is important that the above described pro forma financial statements not be confused with “pro forma” earnings or “pro forma” financial statements that many firms now report in their annual reports and financial press releases. Many companies in recent years have made up their own definition of pro forma in order to present more favorable financial information than the generally accepted accounting princi- ples (GAAP)-based number required to be reported. By eliminating items such as depreciation, amortization, interest, and tax expense from earnings, for example, some firms have tried to convince users of their annual reports to focus on the “pro forma” amount that is usually a profit, instead of the GAAP-based amount that is usually a loss. (This topic was discussed in Chapter 5.)

Summary of Analysis The analysis of any firm’s financial statements consists of a mixture of steps and pieces that interrelate and affect each other. No one part of the analysis should be interpreted in isolation. Short-term liquidity impacts profitability; profitability begins with sales, which relate to the liquidity of assets. The efficiency of asset management influences the cost and availability of credit, which shapes the capital structure. Every aspect of a firm’s financial condition, performance, and outlook affects the share price. The last step of financial statement analysis is to integrate the separate pieces into a whole, leading to conclusions about the business enter- prise. The specific conclusions drawn will be affected by the original objectives established at the initiation of the analytical process.

The major findings from the analysis of R.E.C. Inc.’s financial statements can be summarized by the following strengths and weaknesses.

Strengths

1. Favorable economic and industry outlook; firm well-positioned geographically to benefit from expected economic and industry growth

2. Aggressive marketing and expansion strategies 3. Recent improvement in management of accounts receivable and inventory 4. Successful use of financial leverage and solid coverage of debt service requirements 5. Effective control of operating costs 6. Substantial sales growth, partially resulting from market expansion and reflective

of future performance potential 7. Increased profitability in 2007 and strong, positive generation of cash flow from

operations

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Weaknesses

1. Highly sensitive to economic fluctuations and weather conditions 2. Negative cash flow from operating activities in 2006 3. Historical problems with inventory management and some weakness in overall

asset management efficiency 4. Increased risk associated with debt financing

The answers to specific questions regarding R.E.C. Inc. are determined by the values placed on each of the strengths and weaknesses. In general, the outlook for the firm is promising. R.E.C. Inc. appears to be a sound credit risk with attractive investment poten- tial.The management of inventories, a continuation of effective cost controls, and careful timing of further expansion will be critically important to the firm’s future success.

This book began with the notion that financial statements should serve as a map to successful business decision making, even though the user of financial statement data would confront mazelike challenges in seeking to find and interpret the necessary infor- mation. The chapters have covered the enormous volume of material found in corporate financial reporting, the complexities and confusions created by accounting rules and choices, the potential for management manipulations of financial statement results, and the difficulty in finding necessary information.The exploration of financial statements has required a close examination of the form and content of each financial statement pre- sented in corporate annual reporting as well as the development of tools and techniques for analyzing the data. It is the hope of the authors that readers of this book will find that financial statements are a map, leading to sound and profitable business decisions.

FIGURE 6.4 The Maze Becomes a Map

Auditor's report

Financial reporting quality

Financial statements

Analytical tools and

techniques

Common sense and judgment

Success on Wall Street

Notes

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224 CHAPTER 6 The Analysis of Financial Statements

SELF-TEST Solutions are provided in Appendix B.

1. What is the first step in an analysis of financial statements? (a) Check the auditor’s report. (b) Check references containing financial information. (c) Specify the objectives of the analysis. (d) Do a common size analysis.

2. What is a creditor’s objective in performing an analysis of financial statements? (a) To decide whether the borrower has the ability to repay interest and

principal on borrowed funds. (b) To determine the firm’s capital structure. (c) To determine the company’s future earnings stream. (d) To decide whether the firm has operated profitably in the past.

3. What is an investor’s objective in financial statement analysis? (a) To determine if the firm is risky. (b) To determine the stability of earnings. (c) To determine changes necessary to improve future performance. (d) To determine whether an investment is warranted by estimating a

company’s future earnings stream. 4. What information does the auditor’s report contain?

(a) The results of operations. (b) An unqualified opinion. (c) An opinion as to the fairness of the financial statements. (d) A detailed coverage of the firm’s liquidity, capital resources, and

operations. 5. Which of the following would be helpful to an analyst evaluating the

performance of a firm? (a) Understanding the economic and political environment in which the

company operates. (b) Reviewing the annual reports of a company’s suppliers, customers,

and competitors. (c) Preparing common-size financial statements and calculating key

financial ratios for the company being evaluated. (d) All of the above.

6. Which of the following is not required to be discussed in the Management Discussion and Analysis of the Financial Condition and Results of Operations? (a) Liquidity. (b) Capital resources. (c) Operations. (d) Earnings projections.

7. What type of information found in supplementary schedules is required for inclusion in an annual report? (a) Segmental data. (b) Inflation data.

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8. What is Form 10-K? (a) A document filed with the American Institute of Certified Public

Accountants (AICPA) containing supplementary schedules showing management remuneration and elaborations of financial statement disclosures.

(b) A document filed with the SEC by companies selling securities to the public, containing much of the same information as the annual report as well as additional detail.

(d) A document filed with the SEC containing nonpublic information. 9. What information can be gained from sources such as Industry Norms and

Key Business Ratios,Annual Statement Studies,Analyst’s Handbook, and Industry Surveys? (a) The general economic condition. (b) Forecasts of earnings. (c) Elaborations of financial statement disclosures. (d) A company’s relative position within its industry.

10. Which of the following is not a tool or technique used by a financial statement analyst? (a) Common-size financial statements. (b) Trend analysis. (c) Random sampling analysis. (d) Industry comparisons.

11. What do liquidity ratios measure? (a) A firm’s ability to meet cash needs as they arise. (b) The liquidity of fixed assets. (c) The overall performance of a firm. (d) The extent of a firm’s financing with debt relative to equity.

12. Which category of ratios is useful in assessing the capital structure and long-term solvency of a firm? (a) Liquidity ratios. (b) Activity ratios. (c) Leverage ratios. (d) Profitability ratios.

13. What is a serious limitation of financial ratios? (a) Ratios are screening devices. (b) Ratios can be used only by themselves. (c) Ratios indicate weaknesses only. (d) Ratios are not predictive.

14. What is the most widely used liquidity ratio? (a) Quick ratio. (b) Current ratio. (c) Inventory turnover. (d) Debt ratio.

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226 CHAPTER 6 The Analysis of Financial Statements

15. What is a limitation common to both the current and the quick ratio? (a) Accounts receivable may not be truly liquid. (b) Inventories may not be truly liquid. (c) Marketable securities are not liquid. (d) Prepaid expenses are potential sources of cash.

16. Why is the quick ratio a more rigorous test of short-run solvency than the current ratio? (a) The quick ratio considers only cash and marketable securities as

current assets. (b) The quick ratio eliminates prepaid expenses for the numerator. (c) The quick ratio eliminates prepaid expenses for the denominator. (d) The quick ratio eliminates inventories from the numerator.

17. What does an increasing collection period for accounts receivable suggest about a firm’s credit policy? (a) The credit policy is too restrictive. (b) The firm is probably losing qualified customers. (c) The credit policy may be too lenient. (d) The collection period has no relationship to a firm’s credit policy.

18. Which of the following statements about inventory turnover is false? (a) Inventory turnover measures the efficiency of the firm in managing

and selling inventory. (b) Inventory turnover is a gauge of the liquidity of a firm’s inventory. (c) Inventory turnover is calculated with cost of goods sold in the

numerator. (d) A low inventory turnover is generally a sign of efficient inventory

management. 19. Which of the following items would cause the cash conversion cycle to

decrease? (a) Increasing days payable outstanding. (b) Increasing the average collection period. (c) Increasing the days inventory held. (d) None of the above.

20. What do the asset turnover ratios measure? (a) The liquidity of the firm’s current assets. (b) Management’s effectiveness in generating sales from investments

in assets. (c) The overall efficiency and profitability of the firm. (d) The distribution of assets in which funds are invested.

21. Which of the following ratios would not be used to measure the extent of a firm’s debt financing? (a) Debt ratio. (b) Debt to equity. (c) Times interest earned. (d) Long-term debt to total capitalization.

22. Why is the amount of debt in a company’s capital structure important to the financial analyst? (a) Debt implies risk.

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(b) Debt is less costly than equity. (c) Equity is riskier than debt. (d) Debt is equal to total assets.

23. Why is the fixed charge coverage ratio a broader measure of a firm’s coverage capabilities than the times interest earned ratio? (a) The fixed charge ratio indicates how many times the firm can cover

interest payments. (b) The times interest earned ratio does not consider the possibility of

higher interest rates. (c) The fixed charge ratio includes lease payments as well as interest

payments. (d) The fixed charge ratio includes both operating and capital leases

while the times interest earned ratio includes only operating leases. 24. Which profit margin measures the overall operating efficiency of the firm?

(a) Gross profit margin. (b) Operating profit margin. (c) Net profit margin. (d) Return on equity.

25. Which ratio or ratios measure the overall efficiency of the firm in managing its investment in assets and in generating return to shareholders? (a) Gross profit margin and net profit margin. (b) Return on investment. (c) Total asset turnover and operating profit margin. (d) Return on investment and return on equity.

26. What does a financial leverage index greater than one indicate about a firm? (a) The unsuccessful use of financial leverage. (b) Operating returns more than sufficient to cover interest payments on

borrowed funds. (c) More debt financing than equity financing. (d) An increased level of borrowing.

27. What does the price to earnings ratio measure? (a) The “multiple” that the stock market places on a firm’s earnings. (b) The relationship between dividends and market prices. (c) The earnings for one common share of stock. (d) The percentage of dividends paid to net earnings of the firm.

Use the following data to answer questions 28 through 31:

JDL Corporation Selected Financial Data December 31, 2009

Current assets $150,000 Current liabilities 100,000 Inventories 50,000 Accounts receivable 40,000 Net sales 900,000 Cost of goods sold 675,000

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28. JDL’s current ratio is: (a) 1.0 to 1. (b) 0.7 to 1. (c) 1.5 to 1. (d) 2.4 to 1.

29. JDL’s quick ratio is: (a) 1.0 to 1. (b) 0.7 to 1. (c) 1.5 to 1. (d) 2.4 to 1.

30. JDL’s average collection period is: (a) 6 days. (b) 11 days. (c) 16 days. (d) 22 days.

31. JDL’s inventory turnover is: (a) 1.25 times. (b) 13.5 times. (c) 3.0 times. (d) 37.5 times.

Use the following data to answer questions 32 through 35:

RQM Corporation Selected Financial Data December 31, 2009

Net sales $1,800,000 Cost of goods sold 1,080,000 Operating expenses 315,000 Net operating income 405,000 Net income 195,000 Total stockholders’ equity 750,000 Total assets 1,000,000 Cash flow from operating activities 25,000

32. RQM’s gross profit margin, operating profit margin, and net profit margin, respectively, are: (a) 40.00%, 22.50%, 19.50% (b) 60.00%, 19.50%, 10.83% (c) 60.00%, 22.50%, 19.50% (d) 40.00%, 22.50%, 10.83%

33. RQM’s return on equity is: (a) 26% (b) 54% (c) 42% (d) 19%

34. RQM’s return on investment is: (a) 22.5% (b) 26.5%

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35. RQM’s cash flow margin is: (a) 1.4% (b) 2.5% (c) 10.8% (d) 12.8%

STUDY QUESTIONS AND PROBLEMS 6.1. Eleanor’s Computers is a retailer of computer products. Using the financial data provided,

complete the financial ratio calculations for 2007. Advise management of any ratios that indicate potential problems and provide an explanation of possible causes of the problems.

Industry Averages

Financial Ratios 2005 2006 2007 2007

Current ratio 1.71X 1.65X 1.70X Quick ratio .92X .89X .95X Average collection period 60 days 60 days 65 days Inventory turnover 4.20X 3.90X 4.50X Fixed asset turnover 3.20X 3.33X 3.00X Total asset turnover 1.40X 1.35X 1.37X Debt ratio 59.20% 61.00% 60.00% Times interest earned 4.20X 3.70X 4.75X Gross profit margin 25.00% 23.00% 22.50% Operating profit margin 12.50% 12.70% 12.50% Net profit margin 6.10% 6.00% 6.50% Return on total assets 8.54% 8.10% 8.91% Return on equity 20.93% 20.74% 22.28% Income Statement for Balance Sheet

Year Ended 12/31/07 at 12/31/07 Sales $1,500,000 Cash $ 125,000 Cost of goods sold 1,200,000 Accounts receivable 275,000 Gross profit $ 300,000 Inventory 325,000 Operating expenses 100,000 Current assets $ 725,000 Operating profit $ 200,000 Fixed assets (net) $ 420,000 Interest expense 72,000 Total Assets $1,145,000 Earnings before tax 128,000 Accounts payable $ 150,000 Income tax (0.4) 51,200 Notes payable 225,000 Net Income $ 76,800 Accrued liabilities 100,000

Current liabilities 475,000 Long-term debt 400,000

Total liabilities $ 875,000 Equity 270,000 Total liabilities

and equity $1,145,000

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6.2. Luna Lighting, a retail firm, has experienced modest sales growth over the past three years but has had difficulty translating the expansion of sales into improved profitability. Using three years’ financial statements, you have developed the following ratio calculations and industry comparisons. Based on this information, suggest possible reasons for Luna’s prof- itability problems.

Industry 2009 2008 2007 2009

Current 2.3X 2.3X 2.2X 2.1X Average collection period 45 days 46 days 47 days 50 days Inventory turnover 8.3X 8.2X 8.1X 8.3X Fixed asset turnover 2.7X 3.0X 3.3X 3.5X Total asset turnover 1.1X 1.2X 1.3X 1.5X Debt ratio 50% 50% 50% 54% Times interest earned 8.1X 8.2X 8.1X 7.2X Fixed charge coverage 4.0X 4.5X 5.5X 5.1X Gross profit margin 43% 43% 43% 40% Operating profit margin 6.3% 7.2% 8.0% 7.5% Net profit margin 3.5% 4.0% 4.3% 4.2% Return on assets 3.7% 5.0% 5.7% 6.4% Return on equity 7.4% 9.9% 11.4% 11.8%

6.3. RareMetals, Inc. sells a rare metal found only in underdeveloped countries overseas. As a result of unstable governments in these countries and the rarity of the metal, the price fluctuates significantly. Financial information is given assuming the use of the first- in, first-out (FIFO) method of inventory valuation and also the last-in, first-out (LIFO) method of inventory valuation. Current assets other than inventory total $1,230 and current liabilities total $1,600. The ending inventory balances are $1,350 for FIFO and $525 for LIFO.

Raremetals, Inc. Income Statements (in Thousands)

FIFO LIFO Net sales $3,000 $3,000

Cost of goods sold 1,400 2,225 Gross profit 1,600 775 Selling, general and administrative 600 600

Operating profit 1,000 175 Interest expense 80 80 Earnings before taxes 920 95 Provision for income taxes 322 33 Net earnings $ 598 $ 62

Required

a. Calculate the following ratios assuming RareMetals, Inc. uses the FIFO method of inventory valuation: gross profit margin, operating profit margin, net profit margin, current ratio, and quick ratio.

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b. Calculate the ratios listed in (a) assuming RareMetals, Inc. uses the LIFO method of inventory valuation.

c. Evaluate and explain the differences in the ratios calculated in (a) and (b). d. Will cash flow from operating activities differ depending on the inventory valuation

method used? If so, estimate the difference and explain your answer.

6.4. Eastman Kodak Company and Canon, Inc. are competitors in the camera manufacturing industry. The following ratios and financial information have been compiled for these two companies:

Financial ratios (2000) Kodak Canon Liquidity Current (times) .88 1.71 Quick (times) .61 1.21 Cash flow liquidity (times) .20 .87 Cash flow from operations (millions of $) 982 2,610 Activity Accounts receivable turnover (times) 5.27 5.80 Inventory turnover (times) 4.67 3.21 Payables turnover (times) 2.45 3.55 Fixed asset turnover (times) 2.36 3.60 Total asset turnover (times) .98 .98 Leverage Debt ratio (%) 75.88 54.13 Times interest earned (times) 12.44 16.39 Cash interest coverage (times) 9.84 30.39 Cash flow adequacy (times) .40 1.29 Profitability Gross profit margin (%) 42.70 43.28 Operating profit margin (%) 15.82 8.84 Net profit margin (%) 10.05 4.82 Cash flow margin (%) 7.02 12.46 Return on assets (%) 9.90 4.73 Return on equity (%) 41.04 10.33 Cash return on assets (%) 6.91 12.24 Earnings per share 4.62 1.16 Closing stock price $39 per share $34 per share

Required

a. Compare and evaluate the strengths and weaknesses of Eastman Kodak and Canon. b. Calculate the price-to-earnings (PE) ratios for both firms. Explain what a PE ratio

tells an analyst. What could be the cause of the difference between Eastman Kodak’s and Canon’s PE ratios?

6.5. Determine the effect on the current ratio, the quick ratio, net working capital (current assets less current liabilities), and the debt ratio (total liabilities to total assets) of each of the follow- ing transactions. Consider each transaction separately and assume that prior to each transac- tion the current ratio is 2X, the quick ratio is 1X, and the debt ratio is 50%.The company uses an allowance for doubtful accounts.

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Use I for increase, D for decrease, and N for no change.

Net Current Quick Working Debt

Ratio Ratio Capital Ratio (a) Borrows $10,000 from bank on short-term note (b) Writes off a $5,000 customer account (c) Issues $25,000 in new common stock for cash (d) Purchases for cash $7,000 of new equipment (e) $5,000 inventory is destroyed by fire (f) Invests $3,000 in short-term marketable securities (g) Issues $10,000 long-term bonds (h) Sells equipment with book value of $6,000 for $7,000 (i) Issues $10,000 stock in exchange for land (j) Purchases $3,000 inventory for cash

(k) Purchases $5,000 inventory on credit (l) Pays $2,000 to supplier to reduce account payable

6.6. Laurel Street, president of Uvalde Manufacturing Inc. is preparing a proposal to present to her board of directors regarding a planned plant expansion that will cost $10 million. At issue is whether the expansion should be financed with debt (a long-term note at First National Bank of Uvalde with an interest rate of 15%) or through the issuance of common stock (200,000 shares at $50 per share).

Uvalde Manufacturing currently has a capital structure of: Debt (12% interest) 40,000,000 Equity 50,000,000

The firm’s most recent income statement is presented next: Sales $100,000,000 Cost of goods sold 65,000,000 Gross profit 35,000,000 Operating expenses 20,000,000 Operating profit 15,000,000 Interest expense 4,800,000 Earnings before tax 10,200,000 Income tax expense (40%) 4,080,000 Net income $ 6,120,000 Earnings per share (800,000 shares) $ 7.65

Laurel Street is aware that financing the expansion with debt will increase risk but could also benefit shareholders through financial leverage. Estimates are that the plant expan- sion will increase operating profit by 20%.The tax rate is expected to stay at 40%.Assume a 100% dividend payout ratio.

Required

a. Calculate the debt ratio, time interest earned, earnings per share, and the financial leverage index under each alternative, assuming the expected increase in operating profit is realized.

b. Discuss the factors the board should consider in making a decision.

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CHAPTER 6 The Analysis of Financial Statements 233

6.7. Using the ratios and information given for Amazon.com, an Internet retailer, analyze the short-term liquidity and operating efficiency of the firm as of 2004.

Financial ratios 2004 2003 Liquidity Current (times) 1.57 1.45 Quick (times) 1.27 1.22 Cash flow liquidity (times) 1.45 1.43 Average collection period 11 days 9 days Days inventory held 33 days 27 days Days payable outstanding 79 days 75 days Cash conversion cycle (35 days) (39 days) Activity Accounts receivable turnover (times) 34.76 40.04 Inventory turnover (times) 11.09 13.63 Payables turnover (times) 4.66 4.89 Fixed asset turnover (times) 28.12 23.47 Total asset turnover (times) 2.13 2.43 Other information Cash flow from operations (millions of $) 567 392 Revenues (millions of $) 6,921 5,264

6.8. The following ratios have been calculated for AMC Entertainment Inc., owner and operator of movie theaters.Analyze the capital structure, long-term solvency, and profitability of AMC.

Financial ratios 2004 2003 Leverage Debt ratio (%) 81.4 81.1 Long-term debt to total capital (%) 72.6 72.2 Debt to equity (times) 4.4 4.3 Times interest earned (times) 1.2 0.7 Cash interest coverage (times) 3.4 2.5 Fixed charge coverage (times) 1.0 0.9 Cash flow adequacy (times) 0.5 1.2 Profitability Gross profit margin (%) 34.5 32.4 Operating profit margin (%) 5.2 3.1 Net profit margin (%) (0.6) (1.7) Cash flow margin (%) 10.3 7.2 Return on assets (%) (0.7) (2.0) Return on equity (%) (3.8) (10.6) Cash return on assets (%) 12.2 8.7

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6.9. Writing Skills Problem R.E.C. Inc.’s staff of accountants finished preparing the financial statements for 2007 and will meet next week with the company’s CEO as well as the Director of Investor Relations and representatives from the marketing and art departments to design the current year’s annual report.

Required

Write a paragraph in which you present the main idea(s) you think the company should present to shareholders in the annual report.

6.10. Research Problem Using the articles referenced in footnote 4 in this chapter regarding cash flow ratios, create a list of cash flow ratios that you believe would be a good set of ratios to assess the cash flows of a firm. Choose an industry and locate four companies in that industry. Calculate the cash flow ratios for each company and then create an industry average of all four companies. Comment on how well you think your industry average would work as a guide when analyz- ing other firms in this industry.

6.11. Internet Problem Choose an industry and find four companies in that industry. Using a financial Internet database such as www.marketwatch.com, calculate or locate the four market ratios discussed in the chapter for each of the four companies. Write an analysis comparing the market ratios of the four companies.

6.12. Intel Problem The 2004 Intel Annual Report can be found at the following Web site: www.prenhall. com/fraser. (a) Using the Intel Annual Report, calculate key financial ratios for all years presented. (b) Using the library, find industry averages to compare to the calculations in (a). (c) Write a report to the management of Intel. Your report should include an evaluation

of short-term liquidity, operating efficiency, capital structure and long-term solvency, profitability, market measures, and a discussion of any quality of financial reporting issues. In addition, strengths and weaknesses should be identified, and your opinion of the investment potential and the creditworthiness of the firm should be conveyed to management.

Hint: Use the information from the Intel Problems at the end of Chapters 1 through 5 to com- plete this problem.

6.13. Eastman Kodak Comprehensive Analysis Problem Using the Financial Statement Analysis Template Each chapter in the textbook contains a continuation of this problem. The objective is to learn how to do a comprehensive financial statement analysis in steps as the content of each chapter is learned. Using the 2004 Eastman Kodak Annual Report or Form 10-K, which can be found at www.prenhall.com/fraser, complete the following requirements: (a) Open the financial statement analysis template that you have been using in the prior

chapters. Link to the “Ratios” by clicking on the tab at the bottom of the template. All of the ratios should be automatically calculated for you, assuming you have input all required data from prior chapters. Print this page.

(b) Using all of your data and calculations for Eastman Kodak from prior chapters, write a comprehensive analysis of the company. Use Figure 6.2 as a guide.

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Case 6.1 Action Performance Companies, Inc.

Action Performance Companies, Inc. designs and sells licensed motorsports collectible and consumer products. In the United States the company is a licensee of among others, NASCAR, Indy Racing League, World of Outlaws, and National Hot Rod Association. In Germany, the firm merchandises Formula One and high- end auto manufacturer die-cast replica vehicles. The company outsources most of the production, but retains ownership of the designs and tooling. Products are marketed through distributors, trackside stores, mass-merchant retailers and collec- tors’ catalog club, television program- ming, and Internet sites managed by QVC.

In September 2003, Funline Merchandise Co., Inc. (Funline) was acquired by Action Performance Companies, Inc. Funline distrib- utes non-NASCAR die-cast vehicles. Selected information from the 2004 Form 10-K of

Action Performance Companies, Inc. is on pages 236–241.*

Required 1. Analyze the firm’s financial statements

and supplementary information.Your analysis should include the preparation of common-size financial statements, key financial ratios, and an evaluation of short-term liquidity, operating effi- ciency, capital structure and long-term solvency, profitability, and market mea- sures. (The financial statement analysis template can be accessed and used at www.prenhall.com/fraser.)

2. Identify the strengths and weaknesses of the company.

3. What is your opinion of the invest- ment potential and the creditworthi- ness of Action Performance Companies, Inc.?

C A S E S

Case 6.1 Action Performance Companies, Inc.

CHAPTER 6 The Analysis of Financial Statements 235

*Source: Action Performance Companies, Inc. 2004 Form 10-K.

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ACTION PERFORMANCE COMPANIES, INC. CONSOLIDATED BALANCE SHEETS

September 30, 2004, and 2003 (in Thousands, Except per Share Data)

2004 2003

Assets Current Assets:

Cash and cash equivalents $ 12,580 $ 49,462 Accounts receivable, net of allowance of $9,367 and $3,634 51,769 69,890 Inventories 56,947 43,232 Prepaid royalties 2,834 4,470 Taxes receivable 2,126 – Deferred income taxes 8,766 5,291 Prepaid expenses and other 5,920 3,161

Total current assets 140,942 175,506 Long-Term Assets:

Property and equipment, net 64,878 62,951 Goodwill 88,653 87,448 Licenses and other intangibles, net 56,614 44,426 Other 3,196 2,357

Total long-term assets 213,341 197,182 $ 354,283 $372,688

Liabilities and Shareholders’ Equity Current Liabilities:

Accounts payable $ 28,778 $ 36,734 Accrued royalties 10,702 9,692 Accrued expenses 8,757 11,764 Taxes payable 1,742 3,156 Current portion of long-term debt 4,009 567

Total current liabilities 53,988 61,913 Long-Term Liabilities:

Deferred income taxes 24,979 10,890 43⁄4% convertible subordinated notes – 29,935 Other long-term debt 11,882 4,490 Other 298 926

Total long-term liabilities 37,159 46,241 Minority Interests 2,509 2,941 Commitments and Contingencies Shareholders’ Equity:

Preferred stock, no par value, 5,000 shares authorized, no shares issued and outstanding – –

Common stock, $.01 par value, 62,500 shares authorized; 18,560 and 18,464 shares issued 186 185

Additional paid-in capital 158,429 157,301 Treasury stock, at cost, 190 and 190 shares (3,999) (3,999) Accumulated other comprehensive loss (1,456) (2,488) Retained earnings 107,467 110,594

Total shareholders’ equity 260,627 261,593 $ 354,283 $372,688

The accompanying notes are an integral part of these consolidated financial statements.

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ACTION PERFORMANCE COMPANIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

Years Ended September 30, 2004, 2003, and 2002 (in Thousands, Except per Share Data)

2004 2003 2002 Net sales $ 344,330 $ 369,458 $ 406,558 Cost of sales 247,959 245,879 250,810 Gross profit 96,371 123,579 155,748 Operating expenses:

Selling, general, and administrative 90,713 82,598 76,870 Amortization of licenses and other intangibles 3,802 3,416 2,797

Total operating expenses 94,515 86,014 79,667 Income from operations 1,856 37,565 76,081 Interest expense (1,832) (2,085) (3,029) Gain (loss) on extinguishment of debt (322) 34 (1,361) Foreign exchange gains 1,545 3,574 1,500 Earnings from joint venture 1,370 62 – Other income 204 485 773 Other expense (1,215) (1,909) (1,411) Income before income taxes 1,606 37,726 72,553 Income taxes 1,066 13,499 27,606 Net income 540 24,227 44,947 Currency translation 1,032 2,118 1,019 Comprehensive income $ 1,572 $ 26,345 $ 45,966

Earnings Per Common Share: Basic $ 0.03 $ 1.36 $ 2.56 Diluted $ 0.03 $ 1.33 $ 2.41

The accompanying notes are an integral part of these consolidated financial statements.

Debt and Financing Other long-term debt consists of the following at September 30 (in thousands):

2004 2003 Term Loan A due June 30, 2008, variable rate $ 1,644 $ – Term Loan B due June 30, 2007, variable rate 9,444 – Notes payable, secured by property and equipment, 6.0% to 8.4% 4,803 5,057 Less current portion (4,009) (567)

$ 11,882 $ 4,490

On August 2, 2004, we redeemed $29.9 mil- lion of 43⁄4% convertible subordinated notes at a price of 100.68% for cash of $30.1 million. We funded the redemption with cash on hand, revolving credit facility borrowings, and the term loans under the loan and security

agreement.The subordinated notes were con- vertible, at the option of the holders, into shares of common stock at the initial conver- sion price of $48.20 per share, subject to adjustments in certain events and would have matured on April 1, 2005.

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ACTION PERFORMANCE COMPANIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended September 30, 2004, 2003, and 2002 (in Thousands)

2004 2003 2002 Cash Flows From Operating Activities: Net income $ 540 $ 24,227 $ 44,947 Adjustments to reconcile net income to net cash

provided by operating activities- Deferred income taxes (885) 3,354 (133) Depreciation and amortization 30,184 26,153 23,722 (Gain) loss on extinguishment of debt 322 (34) 1,361 Stock option tax benefits 142 623 2,864 Undistributed earnings from joint venture (1,370) (62) – Other 1,149 982 1,976

Change in assets and liabilities, net of businesses acquired and disposed:

Accounts receivable, net of allowance 18,456 (1,865) (18,518) Inventories (13,077) (363) (4,522) Prepaid royalties 3,706 15 3,285 Other assets (2,785) 2,890 (2,116) Accounts payable and accrued expenses (9,469) (6,117) 5,869 Accrued royalties (1,167) (4,241) (1,655) Taxes payable and receivable, net (3,660) (1,851) (3,366) Other liabilities (2,273) (4,285) (989)

Net cash provided by operating activities 19,813 39,426 52,725

Cash Flows From Investing Activities: Property and equipment purchases (24,940) (33,366) (25,800) Property and equipment sales proceeds 84 245 261 Acquisitions of businesses and intangibles, net of costs (8,142) (15,733) (19,006) Other 615 – (238)

Net cash used in investing activities (32,383) (48,854) (44,783)

Cash Flow From Finanving Activities: Long-term debt borrowings 11,700 3,001 – Long-term debt repayments (31,303) (9,429) (6,397) Stock option and other exercise proceeds 330 871 6,618 Common stock purchases for treasury – (2,024) (1,975) Dividends paid - common shareholders (3,663) (2,497) – Dividends paid - minority interest shareholders (1,609) (1,256) (1,353)

Net cash used in financing activities (24,545) (11,334) (3,107) Effect of exchange rate changes on cash and cash

equivalents 233 639 236 Net change in cash and cash equivalents (36,882) (20,123) 5,071 Cash and cash equivalents, beginning of year 49,462 69,585 64,514 Cash and cash equivalents, end of year $ 12,580 $ 49,462 $ 69,585

The accompanying notes are an integral part of these consolidated financial statements.

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CHAPTER 6 The Analysis of Financial Statements 239

Income Taxes A reconciliation of the federal income tax rate to the Company’s effective rate follows:

2004 2003 2002 Statutory federal rate 34% 35% 35% State taxes, net of federal benefit (2) 2 2 Foreign incremental rate 28 2 1 Valuation allowances and other 6 (3) –

66% 36% 38%

Supplemental Cash Flow Information The supplemental cash flow disclosures follow (in thousands):

2004 2003 2002 Supplemental disclosures:

Interest paid $ 2,252 $ 2,199 $ 2,705 Income taxes paid 5,070 11,420 27,815

Commitments and Contingencies Rent expense recognized for noncan- cellable operating leases, net of sublease

income, totaled $3.9 million, $4.1 million, and $2.1 million for 2004, 2003 and 2002.

Contractual Obligations and Commercial Commitments Aggregate future minimum payments due contractually under royalty agreement guar-

antees, personal service agreements, long- term debt, noncancellable operating leases, commercial letters of credit, and other uncon- ditional purchase obligations are as follows as of September 30, 2004 (in thousands):

Royalty Personal Long- Unconditional Agreement Service term Interest Lease Purchase

Year Guarantees Agreements Debt Payments Payments Obligations Total 2005 $ 19,145 $ 1,514 $ 4,009 $ 260 $ 5,681 $ 12,600 $ 43,209 2006 17,938 843 4,036 238 5,189 – 28,244 2007 15,996 379 3,504 213 4,923 – 25,015 2008 14,514 135 1,036 188 4,092 – 19,965 2009 14,491 135 254 163 3,650 – 18,693 Thereafter 39,695 68 3,052 1,084 10,004 – 53,903 Total $ 121,779 $ 3,074 $ 15,891 $ 2,146 $ 33,539 $ 12,600 $189,029

Year Ended September 30, 2004 Compared with Year Ended September 30, 2003 Net sales decreased to $344.3 million for 2004, compared to $369.5 million in 2003, a

decline of $25.1 million, or 6.8%, from the 2003 fiscal year. Revenues for the year included $42.1 million from Funline, which was acquired in 2003 and con- tributed $0.5 million in that year. Excluding the impact of the Funline

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acquisition, revenues were down $66.8 mil- lion, or 18.1% from 2003.

Domestic die-cast sales decreased $6.2 million, or 4.2%, from the prior year while foreign die-cast sales increased $2.3 million, or 6.6%. The domestic die-cast segment sales decrease of $6.2 million is comprised of a $38.3 million decrease in our wholesale distribution and promotion revenues, a $4.9 million decrease in our die-cast retail collectors’ catalog club revenues, and an offsetting $37.0 million increase in domestic die-cast wholesale sales to mass-merchant retailers. Domestic die-cast wholesale distribution and promo- tion revenues and collector’s catalog club revenues were down as a result of prob- lems in our wholesale distribution network and from a weak NASCAR collector die-cast market. In 2004, approximately one-third of our distributors experienced financial hardships of varying degrees, which impacted both their ordering pat- terns as well as their ability to pay our invoices on a timely basis. The NASCAR collector die-cast market in 2004 suffered from over production of both the number of units in a given production run and the varieties of product offerings. The increase in the variety of production runs made our approval and production process difficult to manage, resulting in a failure to ship product into the market on a timely basis thereby negatively impacting sales. We expect comparable sales from our domestic die-cast wholesale distribution and promotion revenues and collectors’ catalog club revenues in 2005 as we continue to work to improve our die- cast distribution model and focus our product offerings. Domestic die-cast wholesale sales to mass-merchant retailers increased $37.0 million as a result of the $41.7 million impact of increased revenues from Funline, acquired in September 2003, offset by the $4.7 million decrease in

NASCAR die-cast sales to mass-merchant retailers. NASCAR die-cast sales to mass- merchant retailers have been trending up year-over-year in the last two quarters of 2004. We expect double-digit growth in Funline sales in 2005 and single digit growth in NASCAR die-cast sales to mass- merchant retailers, based on merchant feedback.

Year Ended September 30, 2003 Compared with Year Ended September 30, 2002 Net sales decreased 9.1% to $369.5 million for 2003, from $406.6 million in 2002. Domestic die-cast sales decreased $60.6 million, or 29.0%, from the prior year while foreign die-cast sales increased $5.2 million, or 17.7%. Domestic wholesale dis- tribution and promotion die-cast revenues were down in part due to the four-month delay in producing Monte Carlo and Pontiac products arising from the retooling of those products, and in part due to reduced “special paint scheme” product volumes resulting from the lack of high- impact specials and the economic envi- ronment. Mass-merchant retail domestic die-cast revenues were down because our largest customer ordered virtually no prod- uct for delivery in the second half of 2003. The 17.7% increase in foreign die-cast sales approximated the change in the average euro-to-U.S. dollar exchange rate between 2003 and 2002. The increase in domestic apparel and memorabilia segment sales, exclusive of trackside was $23.3 million, or 21.7% from the prior year, and included a $22.5 million increase from businesses acquired in 2002. Trackside sales decreased 8.4% to $52.5 million from revenues of $57.3 million in the prior year. Trackside revenues were impacted by adverse weather conditions and a weak economy.

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CHAPTER 6 The Analysis of Financial Statements 241

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Common Stock Fiscal Year High Low Closing Price

2004: First Quarter $ 19.89 $ 12.58 Second Quarter 18.13 13.57 Third Quarter 15.49 9.74 Fourth Quarter (through December 10, 2004) 11.20 8.37 $ 10.13

2003: First Quarter $ 21.60 $ 14.65 Second Quarter 24.56 16.50 Third Quarter 26.99 18.15 Fourth Quarter 27.71 16.74 $ 24.44

2002: First Quarter $ 50.27 $ 30.03 Second Quarter 51.99 27.75 Third Quarter 34.30 20.68 Fourth Quarter 26.71 15.80 $ 25.70

(A) Amounts indicated as deductions are for amounts charged against these reserves in the ordinary course of business.

(B) Amounts indicated as charged to other accounts represent recoveries of $0.5 million and a reclassification of $1.9 million from allowance for doubtful accounts, long term (Other Assets).

(C) Amounts indicated as charged to other accounts represent a reclassification of ($0.9) million to allowance for doubtful accounts, long term (Other Assets), and ($0.1) million to other liabilities.

(D) Amounts indicated as charged to other accounts represent recoveries of $0.4 million, a reclassification of $(1.0) million to allowance for doubtful accounts, long term (Other Assets), and $0.1 million acquired in the acquisition of Jeff Hamilton Collection, Inc.

ACTION PERFORMANCE COMPANIES, INC. VALUATION AND QUALIFYING ACCOUNTS

Years Ended September 30, 2004, 2003, and 2002 (in Thousands)

Additions— (Charged to) Balance at Charged to or credited

beginning of costs and from other Deductions Balance at Description year expenses accounts (A) end of year Allowance for

doubtful accounts: 2004 $ 3,634 $ 6,768 $ 2,440 (B) $ (3,475) $ 9,367 2003 2,127 3,121 (1,009) (C) (605) 3,634 2002 2,141 1,589 (548) (D) (1,055) 2,127

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Case 6.2 Taser International, Inc. Taser International, Inc. began operations in 1993, and completed an initial public offer- ing in 2001. The firm is the developer and manufacturer of less-lethal self-defense devices sold to law enforcement agencies, commercial airlines, the military, security firms and individuals.

Required 1. Analyze the firm’s financial

statements and supplementary information on pages 242–248. Your analysis should include the prepara- tion of common-size financial

statements, key financial ratios, and an evaluation of short-term solvency, operating efficiency, capital structure and long-term solvency, profitability, and market measures. (The financial statement analysis template can be accessed and used at www.prenhall.com/fraser.)

2. Using your analysis list reasons for and against investment in Taser International, Inc.’s common stock.

3. Using your analysis list reasons for and against loaning Taser International, Inc. additional funds.

Case 6.2 Taser International, Inc. 242 CHAPTER 6 The Analysis of Financial Statements

TASER INTERNATIONAL, INC. STATEMENTS OF INCOME

For the Year Ended December 31, 2004 2003

(As restated see Note 11)

Net Sales $ 67,639,879 $ 24,455,506 Cost of Products Sold: Direct manufacturing expense 16,898,559 6,973,757 Indirect manufacturing expense 5,556,937 2,428,859 Total Cost of Products Sold 22,455,496 9,402,616 Gross Margin 45,184,383 15,052,890 Sales, general and administrative expenses 13,880,322 6,973,721 Research and development expenses 823,593 498,470 Income from Operations 30,480,468 7,580,699 Interest income 439,450 50,375 Interest expense (1,485) (9,307) Other income (expense), net 2,309 (254,476) Income before income taxes 30,920,742 7,367,291 Provision for income tax 12,039,000 2,913,601 Net Income $ 18,881,742 $ 4,453,690 Income per common and common equivalent shares Basic $ 0.33 $ 0.12 Diluted $ 0.30 $ 0.10 Weighted average number of common and common

equivalent shares outstanding Basic 57,232,329 37,889,640 Diluted 62,319,590 46,598,312

The accompanying notes are an integral part of these financial statements.

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TASER INTERNATIONAL, INC. BALANCE SHEETS

December 31, 2004 2003

(As restated see Note 11)

Assets Current Assets Cash and cash equivalents $ 14,757,159 $ 15,878,326 Short-term investments 17,201,477 — Accounts receivable, net 8,460,112 5,404,333 Inventory 6,840,051 3,125,974 Prepaids and other assets 1,639,734 536,815 Income tax receivable 52,973 292,321 Deferred income tax asset 11,083,422 1,137,196 Total Current Assets 60,034,928 26,374,965 Long-term investments 18,071,815 — Property and Equipment, net 14,756,512 3,946,881 Deferred Income Tax Asset 15,310,207 — Intangible Assets, net 1,279,116 1,122,844 Total Assets $109,452,578 $31,444,690

Liabilities and Stockholders’ Equity Current Liabilities Notes payable $ — $ 250,000 Current portion of capital lease obligations 4,642 15,223 Accounts payable and accrued liabilities 8,827,132 3,444,346 Customer deposits 102,165 185,802 Total Current Liabilities 8,933,939 3,895,371 Capital Lease Obligations — 3,655 Deferred Revenue 607,856 78,093 Deferred Income Tax Liability — 40,121 Total Liabilities 9,541,795 4,017,240 Commitments and Contingencies Stockholders’ Equity Preferred Stock, $0.00001 par value per share;

25 million shares authorized; 0 shares issued and outstanding at December 31, 2004 and 2003 — —

Common Stock, $0.00001 par value per share; 200 million shares authorized; 60,992,156 and 50,698,824 shares issued and outstanding at December 31, 2004 and 2003 609 507

Additional Paid-in Capital 75,850,810 22,249,321 Retained Earnings 24,059,364 5,177,622 Total Stockholders’ Equity 99,910,783 27,427,450 Total Liabilities and Stockholders’ Equity $ 109,452,578 $ 31,444,690

The accompanying notes are an integral part of these financial statements.

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TASER INTERNATIONAL, INC. STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2004 2003

(As restated see Note 11)

Cash Flows from Operating Activities: Net income $ 18,881,742 $ 4,453,690 Adjustments to reconcile net income to net cash

provided by operating activities: Loss on disposal of assets — 15,873 Depreciation and amortization 551,793 393,568 Provision for doubtful accounts 90,000 12,908 Provision for warranty 361,058 302,165 Compensatory stock options 625,714 177,142 Deferred income taxes 727,892 (369,627)* Stock option tax benefit 11,321,554 3,315,339* Change in assets and liabilities:

Accounts receivable (3,145,779) (4,529,099) Inventory (3,714,077) (791,165) Prepaids and other assets (1,102,919) (423,066) Income tax receivable 239,348 (217,369) Accounts payable and accrued liabilities 5,551,491 1,853,114 Customer deposits (83,637) 171,074

Net cash provided by operating activities 30,304,180 4,366,546 Cash Flows from Investing Activities:

Purchases of investments (35,273,292) — Purchases of property and equipment (11,322,299) (3,651,110) Purchases of intangible assets (195,397) (565,110)

Net cash used in investing activities (46,790,988) (4,216,220) Cash Flows from Financing Activities:

Payments under capital leases (14,236) (34,026) Payments on notes payable (250,000) (250,000) Payments on revolving line of credit — (385,000) Proceeds from warrants exercised 2,545,065 11,000,519 Proceeds from options exercised 13,084,812 1,819,570

Net cash provided by financing activities 15,365,641 12,151,063 Net (Decrease) Increase In Cash and

Cash Equivalents (1,121,167) 12,301,389 Cash and Cash Equivalents, beginning

of period 15,878,326 3,576,937 Cash and Cash Equivalents, end of period $ 14,757,159 $ 15,878,326 Supplemental Disclosure: Cash paid for interest $ 1,364 $ 9,922 Cash (refunded) paid for income

taxes—net $ (264,026) $ 202,410

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CHAPTER 6 The Analysis of Financial Statements 245

Results of Operations Sales and marketing expenses were also reduced by 31%, to 11% of sales for 2004 compared to 16% for 2003 due to better leverage of the fixed expenses. In total, the Company spent $7.2 million in promoting new sales and servicing existing customers in 2004, compared to $3.8 million for 2003. The most significant increases were in the areas of public relations activities, law enforcement training programs, and travel and salaries expenses. The increase in public relations activities is associated with the Company’s continuing efforts to educate the public in regard to the safety and efficacy of its prod- ucts. In addition, the training programs presented cost the Company $1.1 million for 2004 compared to $482,000 for 2003.

n. Concentration of Credit Risk and Major Customers

Financial instruments that potentially sub- ject the Company to concentrations of credit risk consist of accounts receivable. Sales are typically made on credit and the Company generally does not require collat- eral. The Company performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated potential losses. Accounts receiv- able are presented net of an allowance for doubtful accounts. The allowance for bad debts totaled $120,000 and $30,000 as of December 31, 2004 and 2003, respectively.

The Company sells primarily through a network of unaffiliated distributors. The Company also reserves the right to sell directly to the end user to secure its credit interests. In 2004, the Company had three dis- tributors that met or exceeded 10% of total sales; one of which represented 14% of sales, and two of which individually represented 10% of sales. No other customer exceeded 10% of product sales in 2004. Sales to one U.S. customer represented 15% of total prod- uct sales for 2003. No other customer exceeded 10% of total product sales in 2003.

At December 31, 2004, the Company had receivables from two customers com- prising 21% and 16% of the aggregate accounts receivable balance. These cus- tomers are unaffiliated distributors of the Company’s products.At December 31, 2003, the Company had a receivable from one customer comprising 19% of the aggregate accounts receivable balance. This customer was one of the ten largest U.S. police forces.

The Company currently purchases fin- ished circuit boards and injection-molded plastic components from suppliers located in the Phoenix area.Although the Company currently obtains these components from single source suppliers, the Company owns the injection molded component tool- ing used in their production. As a result, the Company believes it could obtain alternative suppliers in most cases without incurring significant production delays. The

Non Cash Transactions Increase to deferred tax asset related to tax benefits

realized from the exercise of stock options (with a related increase to additional paid in capital of $37,346,000 and 3,961,928) $ 26,024,446 $ 646,589

Note Payable issued for purchase of intangible assets $ — $ 500,000

The accompanying notes are an integral part of these financial statements.

*Due to the 2004 restatement,Taser International filed this statement with the SEC, but these two numbers were restated from the 2003 Annual Report.As a result the column for 2003 does not add correctly. For mathematical purposes it is suggested that the numbers originally filed in 2003 be used, which are as follows: Deferred income taxes, (1,014,217) and Stock option tax benefit 3,961,928.

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Company also purchases small, machined parts from a vendor in Taiwan, custom cartridge assemblies from a proprietary vendor in Arizona, and electronic compo- nents from a variety of foreign and domestic distributors. The Company believes that

there are readily available alternative suppliers in most cases who can consistently meet our needs for these components. The Company acquires most of its components on a purchase order basis and does not have long-term contracts with suppliers.

3. Property and Equipment Property and equipment consist of the following at December 31, 2004 and 2003:

Estimated Useful Life 2004 2003

Leasehold Improvements Lease Term $ 90,658 $ 56,198 Land 2,899,962 2,899,962 Building/Construction in Progress 8,689,046 131,980 Production Equipment 5 Years 1,555,988 1,159,886 Telephone Equipment 5 Years 35,555 35,555 Computer Equipment 3–5 Years 2,501,928 812,869 Furniture and Office Equipment 5–7 Years 834,728 189,117 Total Cost 16,607,865 5,285,567 Less: Accumulated Depreciation 1,851,353 1,338,686 Net Property and Equipment $ 14,756,512 $ 3,946,881

Depreciation expense for the years ended December 31, 2004 and 2003 was $512,668 and $363,899, respectively.

b. Purchase Commitments

The Company has approximately $3,344,000 remaining on the contract to construct its new manufacturing and headquarters facil- ity. The amount due is expected to be paid during 2005.

c. Litigation

Securities Litigation On January 10, 2005, a securities class action lawsuit was filed in the United States District Court for the District of Arizona against the Company and certain of its officers and directors, captioned Malasky v. TASER International,Inc.,et al.,Case No.2:05 CV 115. Since then, numerous other securities class action lawsuits were filed against the Company and certain of its officers and directors.The major- ity of these lawsuits were filed in the District ofArizona.

5. Commitments and Contingencies a. Operating Leases

The Company has entered into operating leases for office space and equipment. Rent expense under these leases for the years ended December 31, 2004 and 2003, was $339,524 and $162,743, respectively.

Future Minimum lease payments under operating leases as of December 31, 2004, are as follows for the years ending December 31:

2005 $ 197,400 2006 19,788 2007 4,113 2008 — 2009 — Thereafter —

$ 221,301

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Shareholder Derivative Litigation

On January 11, 2005, a shareholder derivative lawsuit was filed in the United States District Court for the District of Arizona purportedly on behalf of the Company and against cer- tain of its officers and directors, captioned Goldfine v. Culver, et al., Case No. 2:05 CV 123. Since then, five other shareholder deriv- ative lawsuits were filed in the District of Arizona, two shareholder derivative law- suits were filed in the Arizona Superior Court, Maricopa County, and one share- holder derivative lawsuit was filed in the Delaware Chancery Court. On February 9, 2005, the shareholder derivative actions pending in federal court were consolidated into a single action under the caption, In re TASER International Shareholder Derivative Litigation, Case No. 2:05 CV 123. Pursuant to the consolidating order, defendants will not respond to any of the complaints originally in these actions. Instead, defendants will respond to plaintiffs’ consolidated amended complaint. Defendants have not responded to the cases filed in the Arizona Superior Court or in Delaware Chancery Court.

The complaints in the shareholder derivative lawsuits generally allege that the defendants breached the fiduciary duties owed to the Company and its shareholders by reason of their positions as officers and/or directors of the Company. The com- plaints claim that such duties were breached by defendants’ disclosure of allegedly false or misleading statements about the safety and effectiveness of Company products and the Company’s financial prospects. The complaints also claim that fiduciary duties were breached by defendants’ alleged use of non-public information regarding the safety of Company products and the Company’s financial condition and future business prospects for personal gain through the sale of the Company’s stock. The Company is named solely as a nominal defendant against which no recovery is sought.

Securities and Exchange Commission Informal Inquiry

The Securities and Exchange Commission has initiated an informal inquiry into Taser with respect to the basis for the Company’s public statements concerning the safety and performance of the Company’s products, disclosure issues and the accounting for cer- tain transactions. The inquiry is ongoing.

Product Liability Litigation

From April 2003 to March 2005, the Company was named as a defendant in 18 lawsuits in which the plaintiffs alleged either wrongful death or personal injury in situa- tions in which the TASER device was used by law enforcement officers or during train- ing exercises. One case has been dismissed with prejudice, another case has been dis- missed without prejudice and the balance of the cases are pending.We have submitted the defense of each of these lawsuits to our insur- ance carriers as we maintained during these periods and continue to maintain product lia- bility insurance coverage with varying limits and deductibles. The Company’s product lia- bility insurance coverage during these peri- ods ranged from $5,000,000 to $10,000,000 in coverage limits and from $10,000 to $250,000 in deductibles. The Company is defending each of these lawsuits vigorously.

11. Restatement In April 2005, subsequent to the issuance of our financial statements for the year ended December 31, 2004, we discovered an error in that certain stock option grants were treated as incentive stock options when the grants should have been classified as non-statutory stock options because of the annual limitation on incentive stock options under applicable tax regulations. For employees who exercised stock option grants and held the underlying stock, to the extent such option grants should have been

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classified as non-statutory stock options (as opposed to incentive stock options), the employee’s taxable compensation was understated and we were entitled to a deduction from our taxable income equal to the amount of additional compensation attributable to the exercise of non-statutory stock options. This resulted in an increase in our previously reported deferred tax assets at December 31, 2004 by approximately $3.0 million, with a corresponding increase to our additional paid in capital. In addition, while incentive stock options are not subject to payroll tax withholding, non-statutory stock options that result in ordinary income when exercised are subject to payroll tax withholding for the employee and an equal amount to be paid by the employer. The impact to us in the year ended December 31, 2004 of the additional payroll tax withholding was approximately $395,000,

which was recorded as an increase to our selling, general and administrative expenses over amounts previously reported. As a result, our provision for income tax decreased by approximately $152,000, which resulted in a corresponding increase in our deferred tax assets. This adjustment impacted our previously reported net income for the year ended December 31, 2004 by approximately $243,000 which reduced our diluted earnings per share for such period by $0.01 to $0.30. The change in net income was not significant enough to affect basic earnings per share for the year ended December 31, 2004.

Closing Stock Price (adjusted for stock splits)

12-31-04 $31.65 12-31-03 $ 6.86

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A p p e n d i x 6 A

The Analysis of Segmental Data

Beginning in calendar year 1998, com- panies were required by the provisions of FASB Statement No. 131, “Disclosures about Segments of an Enterprise and Related Information,” to disclose supple- mentary financial data for each reportable segment. FASB Statement No. 131 also covers reporting requirements for foreign operations, sales to major customers, and disclosures required for enterprises that have only one reportable segment. Seg- mental disclosures are valuable to the financial analyst in identifying areas of strength and weakness within a company, proportionate contribution to revenue and profit by each division, the relationship between capital expenditures and rates of return for operating areas, and seg- ments that should be deemphasized or eliminated. The information on segments is presented as a supplementary section in the notes to the financial statements, as part of the basic financial statements, or in a separate schedule that is refer- enced and incorporated into the financial statements.

An operating segment is defined by FASB Statement No. 131 as a component of a business enterprise:

1. That engages in business activities from which it may earn revenues and incur expenses,

2. Whose operating results are regularly reviewed by the company’s chief operating decision maker to make decisions about resources allocated to the segment and assesses its perfor- mance, and

3. For which discrete financial informa- tion is available.

A segment is considered to be reportable if any one of three criteria is met:

1. Revenue is 10% or more of com- bined revenue, including intersegment revenue.

2. Operating profit or loss is 10% or more of the greater of combined profit of all segments with profit or com- bined loss of all segments with loss.

3. Segment assets exceed 10% or more of combined assets of all segments.

The following information must be dis- closed according to FASB Statement No. 131:

1. General Information. The “manage- ment approach” is used to identify operating segments in the enterprise. The management approach is based on the way that management organizes the segments within the company for making operating decisions and assess- ing performance. A company must identify how it is organized and what factors were used to identify operating segments and describe the types of products and services from which each operating segment derives its revenues.

2. Information About Profit or Loss. A company must report a measure of profit or loss for each reportable seg- ment. In addition, certain amounts must be disclosed if the specified amounts are included in information reviewed by the chief operating deci- sion maker. For companies basing profit or loss on pretax income from

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continuing operations, the following amounts must be disclosed1:

• Revenues (separated into sales to external customers and intersegment sales)

• Interest revenue • Interest expense • Depreciation, depletion, and

amortization expense

3. Information About Assets. A company must report a measure of the total operating segments’ assets. Only assets included in reports to the chief operat- ing decision maker should be included. The total capital expenditures that have been added to long-lived assets must also be reported for each operat- ing segment.

The total of the operating segments’ revenues, profit or loss, assets, and any other items reported shall be reconciled to the company’s total consolidated amounts for each of these items.

The following analysis of Motorola’s segment disclosures provides an illustration of how to interpret segmental data.

Exhibit 6A.1 illustrates an excerpt from the general information and the geographic area information disclosed by Motorola, Inc. in the Company’s 2004 annual report. Exhibit 6A.2 illustrates the revenue, profit (loss), assets, capital expenditures, and depreciation expense for Motorola’s six reportable segments: Personal Communications; Global Telecom Solutions; Commercial, Government, and Industrial Solutions; Integrated Electronic Systems; Broadband Communications; and Other Products. Segmental reporting does not include complete financial statements,

but it is feasible to perform an analysis of the key financial data presented.

Refer first to Exhibit 6A.1. The majority of Motorola’s sales are from the United States. With the exception of China, sales have increased each year in all geographic regions.

Referring to Exhibit 6A.2, notice that total revenue for Motorola declined in 2003, but rebounded in 2004. The company is now generating overall operating profits in 2004 compared to operating losses in 2002. In order to analyze the performance for each segment, six tables have been prepared from computations based on the figures provided in Exhibit 6A.2.

Table 6A.1 shows the percentage of contribution to total revenue by segment. Note the change in trends over the three- year period. Personal Communications not only continues to be the largest revenue producer, but also is contributing more in 2004 to total revenues. All other segments are contributing less to revenue in 2004 compared to 2002.

Table 6A.2 reveals the contribution by segment to operating profit or loss and provides a basis for assessing the ability of a segment to translate revenue into profit. Personal Communications was the leading contributor to operating profit in 2004. Global Telecom Solutions contributed positively to operating profits in 2004 and has improved significantly since operating at a loss in 2002. Commercial, Government, and Industrial Solutions and Integrated Electronic Systems have continued to generate operating profits but have declined significantly from 2002 to 2004 in the percentage of profit generated overall. Broadband Communications and Other Products generated operating losses in 2002 and 2003, but Broadband Communications is now generating a profit in 2004 and Other Products has generated less of a loss compared to 2002.

1If more complex profit measures are used, the com- pany must also disclose any unusual items, equity income, income tax expense, extraordinary items, and other significant noncash items.

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EXHIBIT 6A.1 Information by Segment and Geographic Region, Motorola Inc.

The Company’s reportable segments have been determined based on the nature of the products offered to customers and are comprised of the following:

• The Personal Communications segment (“PCS”) designs, manufactures, sells and services wireless handsets with integrated software and accessory products.

• The Global Telecom Solutions segment (“GTSS”) designs, manufactures, sells, installs, and services wireless infrastructure communication systems, including hardware and software. GTSS provides end-to-end wireless networks, including radio base stations, base site controllers, associated software and services, mobility soft switching, application platforms and third-party switching for CDMA 2000, GSM, iDEN® and UMTS technologies.

• The Commercial, Government and Industrial Solutions segment (“CGISS”) designs, manufactures, sells, installs, and services analog and digital two-way radio, voice and data communications products and systems to a wide range of public-safety, government, utility, courier, transportation and other worldwide markets.The segment continues to invest in the market for broadband data, including infrastructure, devices, service and applications. In addition, the segment participates in the expanding market for integrated information management, mobile and biometric applications and services.

• The Integrated Electronic Systems segment (“IESS”) designs, manufactures and sells: (i) automotive and industrial electronics systems, (ii) telematics systems that enable automated roadside assistance, navigation and advanced safety features for automobiles, (iii) portable energy storage products and systems, and (iv) embedded computing systems.

• The Broadband Communications segment (“BCS”) designs, manufactures and sells a wide variety of broadband products, including: (i) digital systems and set-top terminals for cable television and broadcast networks, (ii) high speed data products, including cable modems and cable modem termination systems, as well as Internet Protocol-based telephony products, (iii) access network technology, including hybrid fiber coaxial network transmission systems and fiber-to-the-premise transmission systems, used by cable television operators, (iv) digital satellite television systems; (v) direct-to-home satellite networks and private networks for business communications, and (vi) high-speed data, video and voice broadband systems over existing phone lines.

• Other is comprised of the Other Products segment and general corporate items. The Other Products segment includes: (i) various corporate programs representing developmental businesses and research and development projects, which are not included in any major segment, and (ii) Motorola Credit Corporation, the Company’s wholly-owned finance subsidiary.

Geographic Area Information (Dollars in Millions)

Property, Plant, and Net Sales* Assets** Equipment

Years Ended December 31 2004 2003 2002 2004 2003 2002 2004 2003 2002

United States $18,693 $15,570 $14,400 $19,580 $19,190 $18,910 $1,304 $1,406 $1,599

China 4,639 3,679 4,431 3,565 2,450 2,654 218 242 294

Germany 2,824 1,796 1,591 975 581 441 141 137 140

Other nations 16,915 10,217 9,869 11,480 8,734 6,913 699 707 852

Adjustments and Eliminations (11,748) (8,107) (6,869) (4,711) (4,153) (3,874) (30) (19) (22)

$31,323 $23,155 $23,422 $30,889 $26,802 $25,044 $2,332 $2,473 $2,863

* As measured by the location of the revenue-producing operations. ** Excludes assets from discontinued operations of $5.2 billion and $6.2 billion, at December 31, 2003

and 2002, respectively.

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EXHIBIT 6A.2 Motorola Inc. and Subsidiaries Segment Information (Dollars in Millions)

Operating Net Sales Earnings (Loss)

Years Ended December 31 2004 2003 2002 2004 2003 2002

Personal Communications Segment $16,823 $10,978 $11,174 $1,708 $479 $503

Global Telecom Solutions Segment 5,457 4,417 4,611 759 247 (621)

Commercial, Government and Industrial Solutions Segment 4,588 4,131 3,749 753 562 313

Integrated Electronic Systems Segment 2,696 2,265 2,189 142 161 52

Broadband Communications Segment 2,335 1,857 2,143 116 (38) (216)

Other Products Segment 387 323 430 (229) (44) (214)

Adjustments and Eliminations (963) (816) (874) 47 3 13

$31,323 $23,155 $23,422 3,296 1,370 (170)

General Corporate (164) (97) (273)

Operating earnings (loss) 3,132 1,273 (443)

Total other income (expense) 120 103 (1,628)

Earnings (loss) from continuing operations before income taxes $3,252 $1,376 $(2,071)

General Corporate Operating Earnings (Loss) consists of expenses which are not identifiable with segment activity. Such items primarily consist of legal expenses, restructuring costs related to corporate employees and facilities, Iridium-related costs (recoveries), and corporate costs that were not allocated to Freescale Semiconductor in accordance with the discontinued operations presentation.

Capital Depreciation Assets Expenditures Expense

Years Ended December 31 2004 2003 2002 2004 2003 2002 2004 2003 2002

Personal Communications Segment $ 5,292 $ 3,783 $ 3,733 $ 91 $ 74 $ 101 $ 128 $ 159 $ 203

Global Telecom Solutions Segment 2,616 2,746 3,630 91 67 84 129 155 218

Commercial, Government and Industrial Solutions Segment 2,215 1,938 1,961 149 76 83 90 96 115

Integrated Electronic Systems Segment 1,368 1,102 1,032 99 44 55 77 74 75

Broadband Communications Segment 2,314 2,354 2,480 27 23 20 59 66 77

Other Products Segment 391 611 444 — — — 11 9 21

Adjustments and Eliminations (66) (124) (138) — — — 2 — —

14,130 12,410 13,142 457 284 343 496 559 709

General Corporate 16,759 14,392 11,902 37 60 44 65 104 194

Discontinued Operations — 5,244 6,189

$ 30,889 $ 32,046 $ 31,233 $ 494 $ 344 $ 387 $ 561 $ 663 $ 903

General corporate assets include primarily cash and cash equivalents, marketable securities, property, plant and equipment, cost-based investments, deferred income taxes and the administrative headquarters of the Company.

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Operating profit margin (operating profit divided by revenue) is presented for each segment in Table 6A.3. The operating profit margin shows the percent of every sales dollar that is converted to (before- tax) profit. The profit margin is highest and increasing in all three years for the Commercial, Government, and Industrial Solutions segment. All other segments,

except Other Products, have improved operating profit margins from 2002 to 2004. Global Telecom Solutions and Broadband Communications now gener- ate operating profits after having losses in prior years.

Table 6A.4 is a percentage break- down of capital expenditures by segment. Motorola has chosen to invest the most in

TABLE 6A.1 Contribution by Segment to Revenue (Percentages)

2004 2003 2002

Personal Communications 53.71 47.41 47.71 Global Telecom Solutions 17.42 19.08 19.69 Commercial, Government, and Industrial Solutions 14.65 17.84 16.01 Integrated Electronic Systems 8.61 9.78 9.34 Broadband Communications 7.45 8.02 9.14 Other Products 1.23 1.39 1.84 Adjustments and Eliminations (3.07) (3.52) (3.73) Total revenue 100.00 100.00 100.00

TABLE 6A.2 Contribution by Segment to Operating Profit (Loss) (Percentages)

2004 2003 2002

Personal Communications 51.82 34.96 295.88 Global Telecom Solutions 23.03 18.03 (365.29) Commercial, Government, and Industrial Solutions 22.84 41.02 184.12 Integrated Electronic Systems 4.31 11.75 30.59 Broadband Communications 3.52 (2.77) (127.06) Other Products (6.95) (3.21) (125.88) Adjustments and Eliminations 1.43 0.22 7.64 Total revenue 100.00 100.00 (100.00)

TABLE 6A.3 Operating Profit Margin by Segment (Percentages)

2004 2003 2002

Personal Communications 10.15 4.36 4.50 Global Telecom Solutions 13.91 5.59 (13.47) Commercial, Government, and Industrial Solutions 16.41 13.60 8.35 Integrated Electronic Systems 5.27 7.11 2.38 Broadband Communications 4.97 (2.05) (10.08) Other Products (59.17) (13.62) (49.77)

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Commercial, Government, and Industrial Solutions in 2004. This investment has resulted in higher sales and better profit margins. Motorola has continued to invest in Personal Communications and Global Telecom Solutions but at a smaller rate. This has not negatively impacted these segments so it is possible that greater dollar amounts are not necessary in these divisions. Despite spending more in the Integrated Electronic Systems segment in 2004, Motorola has not realized better profits in this segment. Broadband Communications receives the least in capital expenditures but is steadily improving despite the low investment.

It is important to examine the relation- ship between investment and return, and this information is provided in Table 6A.5, which shows return on investment by segment (operating profit divided by identifiable

TABLE 6A.5 Return on Investment by Segment (Percentages) 2004 2003 2002

Personal Communications 32.28 12.66 13.47 Global Telecom Solutions 29.01 8.99 (17.11) Commercial, Government, and Industrial Solutions 34.00 29.00 15.96 Integrated Electronic Systems 10.38 14.61 5.04 Broadband Communications 5.01 (1.61) (8.71) Other Products (58.57) (7.20) (48.20)

TABLE 6A.4 Capital Expenditures by Segment (Percentages)

2004 2003 2002

Personal Communications 19.91 26.06 29.45 Global Telecom Solutions 19.91 23.59 24.49 Commercial, Government, and Industrial Solutions 32.61 26.76 24.20 Integrated Electronic Systems 21.66 15.49 16.03 Broadband Communications 5.91 8.10 5.83 Other Products 0.00 0.00 0.00 Total capital expenditures 100.00 100.00 100.00

assets). All segments except Integrated Electronic Systems (and Other Products) have increasing returns on investments from 2002 to 2004. Given the fact that the major U.S. automobile manufacturers were not doing well in 2004, it is possible that this could be the cause of the lower returns and profits in this segment.

Table 6A.6 compares a ranking of segments in 2004 by segment assets with percentage contribution to operating profit, operating profit margin, and return on investment. Commercial, Government, and Industrial Solutions is the largest segment when considering total investment in assets. Overall Motorola appears to be moving in the right direction in most segments. The two segments that should be monitored closely are Integrated Electronic Systems and Broadband Communications.

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STUDY PROBLEM

TABLE 6A.6 Ranking of Segments in 2004

Percentage of Percent Operating Total Segment Contribution to Profit Return on

Segment Assets Operating Profit Margin Investment

Commercial, Government, and Industrial Solutions 32.61 22.84 16.41 34.00

Integrated Electronic Systems 21.66 4.31 5.27 10.38 Personal Communications 19.91 51.82 10.15 32.28 Global Telecom Solutions 19.91 23.03 13.91 29.01 Broadband Communications 5.91 3.52 4.97 5.01 Other Products 0.00 (6.95) (59.17) (58.57)

6A.1. The 2004 Eastman Kodak segment information from the annual report can be found at the following Web site: www.prenhall.com/fraser. Using the segment information from the 2004 Eastman Kodak annual report, analyze all segments. Be sure to prepare tables comparable to Tables 6A.1 through 6A.6 illustrated in the appendix to the chapter.

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