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chapter 9

Analysis

Learning Goals

• Convert financial statements to a common size and perform trend analysis.

• Perform liquidity analysis by evaluating working capital, the current ratio, and the quick ratio.

• Perform debt service analysis via the debt-to-assets, debt-to-equity, and times- interest-earned ratios.

• Evaluate accounts receivable and inventory turnover.

• Analyze trends in profitability through examining margins and rates of return.

• Calculate earnings per share and book value per share.

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198

CHAPTER 9Section 9.1 Common-Size Financial Statements

Chapter Outline 9.1 Common-Size Financial Statements 9.2 Ratio Analysis 9.3 Liquidity Analysis 9.4 Debt Service Analysis 9.5 Turnover Analysis 9.6 Profitability Analysis 9.7 Other Measures 9.8 Recap and Summary Illustration

By now, you have developed an appreciation for the basic principles and practices used to develop key financial reports. As noted many times, financial statements are intended to benefit investors and creditors in their quest to make informed decisions about buying stock from or lending money to a company. The focus now turns to the analytical process by which information extracted from an accounting system can be examined in a thoughtful and systematic fashion.

Users of financial statements often engage in comparative analysis; that is, they have choices. They can make either equity investments or loans, and they likely have multiple firms to choose from. Clearly, the goal is to maximize anticipated returns based on the risk level that they are willing to entertain. Common-size financial statements and ratio analysis are tools that can facilitate this process.

9.1 Common-Size Financial Statements

The concept of common-size financial statements relates to scaling the dollar amounts within financial statements to percentage terms. The purpose of the scal- ing process is to facilitate comparisons across firms and/or time. There are many ways in which this scaling can occur. The following examples will illustrate a few of the possible scenarios and are sufficient to provide you with a conceptual understanding that you can then adapt to almost any type of evaluation.

Exhibit 9.1 is a comparative income statement for Ace Company for 2 consecutive years. This is the traditional format that you are already well acquainted with.

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CHAPTER 9Section 9.1 Common-Size Financial Statements

Exhibit 9.1: A comparative income statement

The 20X3 income statement reveals a profit of \$48,000, based on \$250,000 in sales. Net income doubled from the prior year’s \$24,000 amount; sales did not. Though apparent that income increased significantly, it is not readily apparent why. The cause for the dou- bling in income can be clarified via both vertical and horizontal analyses.

A vertical analysis of income results when each expense category is expressed as a per- centage of sales. In other words, each item within the vertical column of data is expressed in relation to (as a percentage of) the top item in the column: sales. The vertical analysis in Exhibit 9.2 reveals how each line item component of income relates to revenue, on a percentage basis.

Exhibit 9.2: An income statement showing a vertical analysis

By reviewing this vertical analysis of income, you can readily see that cost of goods sold is about 40% of sales. The remaining gross profit of around 60% is allocated to operating expenses, taxes, and net income. On a relative basis, you can also tell that most expenses were at a fairly steady percentage of sales for both years, with a noted exception for the decrease in operating expenses; indeed, a large portion of the increase in income appears to be due to the reduction in the operating expense proportion.

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net Income

20X3 20X2

Ace Company Income Statement

For the years ending December 31

\$ 250,000

100,000

\$ 150,000

80,000

\$ 70,000

22,000

\$ 48,000

\$ 225,000

95,000

\$ 130,000

88,000

\$ 42,000

18,000

\$ 24,000

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net Income

100.00% 100.00%

40.00% 42.22%

60.00% 57.78%

32.00% 39.11%

28.00% 18.67%

8.80% 8.00%

19.20% 10.67%

Ace Company Income Statement

Vertical Common Size Report For the years ending December 31

20X3 20X2

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CHAPTER 9Section 9.1 Common-Size Financial Statements

A horizontal analysis can be used to compare data from within two or more periods, side-by-side. In other words, it is intended to show the change in certain accounts from two separate accounting periods. Horizontal analysis can be very helpful in looking for trends in a company’s income. Consider Exhibit 9.3 and the comments that follow.

Exhibit 9.3: An income statement showing a horizontal analysis

The horizontal analysis in Exhibit 9.3 shows that sales increased by only 11%, but gross profit increased by 15%. This is reflective of the slightly reduced cost of goods sold per- centage. Operating expenses decreased by 9%, notwithstanding the increase in overall sales. The impacts of the slight improvement in gross profit, coupled with the decrease in operating expenses, resulted in a dramatic rise in income. This type of analysis is not complex or brilliant, but it is illuminating. It will definitely cause you to focus on changes that need to be monitored closely.

Vertical and horizontal analyses are also applicable to balance sheet presentations. These analyses can be used to pinpoint shifts in key business elements, such as a buildup of inventory, capital investments, changing debt levels, and so forth. Many of these impor- tant trends are additionally monitored by ratios that are discussed later in this chapter. But, the common-size financial statements can cause important trends or problems to “pop off the page” and be noticed. You can almost think of this technique like radar, con- stantly scanning financial reports for emerging storm clouds! Examine the balance sheets in Exhibits 9.4, 9.5, and 9.6 and see what trends that you can identify.

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net Income

+ 11%

+ 5%

+ 15%

_ 9%

+ 67%

+ 22%

+ 100%

Ace Company Income Statement

Horizontal Common Size Report 20X3 Change Over 20X2

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CHAPTER 9Section 9.1 Common-Size Financial Statements

Exhibit 9.4: A comparative balance sheet

Exhibit 9.5: A balance sheet showing a vertical analysis

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total Assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

\$ 80,000

135,000

210,000

500,000

190,000

624,000

400,000

\$ 2,139,000

\$ 85,000

810,000

\$ 895,000

\$ 500,000

744,000

\$ 1,244,000

\$ 2,139,000

\$ 100,000

225,000

175,000

600,000

190,000

610,000

435,000

\$ 2,335,000

\$ 143,000

790,000

\$ 933,000

\$ 500,000

902,000

\$ 1,402,000

\$ 2,335,000

Base Corporation Comparative Balance Sheets December 31, 20X5 and X6

20X6 20X5

4.28%

9.64%

7.49%

25.70%

8.14%

26.12%

18.63%

100.00%

3.97%

37.87%

41.84%

23.38%

34.78%

58.16%

100.00%

Base Corporation Balance Sheet

December 31, 20X6 and X5

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total Assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

3.74%

6.31%

9.82%

23.38% 8.88%

29.17% 18.70%

100.00%

6.12% 33.83% 39.96%

21.41% 38.63% 60.04%

100.00%

20X520X6

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202

CHAPTER 9Section 9.2 Ratio Analysis

Exhibit 9.6: A balance sheet showing a horizontal analysis

Common-size financial statements are often reported on investment research websites, in reports prepared by financial statement analysts, and others. The company itself typically does not present them. It is essential that financial statement users and others do their own research and analysis, and converting published financial statements to common- size reports is an excellent starting point.

9.2 Ratio Analysis

An automobile is a complex machine. Think of all the data you must monitor to know that it is functioning correctly. Tire pressure, speed, water temperature, voltage, rpms, and so forth are numbers that you may constantly monitor. Numbers that are out of the normal operating range can serve as early warning signs that something is going wrong. For instance, if the water temperature gauge is rising above 200 degrees, you may suspect that trouble is coming; perhaps your car is losing water from a broken hose. So you fix the minor problem before it becomes major and requires a costly solution. In the same way, investors and creditors may develop their own ratios and keep a watchful eye for trouble. The ratios are divisible into categories related to liquidity measures, debt service, turnover, and profitability. In addition, a host of other measures may be of great interest.

20X6

125.00%

166.67%

83.33%

120.00%

100.00%

97.76%

108.75%

109.16%

168.24%

97.53%

104.25%

100.00% 121.24% 121.70%

109.16%

Base Corporation Balance Sheet

Horizontal Common Size Report December 31, 20X6 and X5

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total Assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

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203

CHAPTER 9Section 9.3 Liquidity Analysis

9.3 Liquidity Analysis

Investors and creditors must be vigilant to monitor a company’s liquidity, or ability to meet near-term obligations as they mature. A company with a strong balance sheet and robust sales can still find itself in deep trouble by running out of cash. This can happen when resources become bound up in receivables, inventory, and plant assets. Therefore, management, investors, and creditors will all follow a company’s liquidity trends and condition. Two ratios, the current and quick ratios, are particularly intended to signal the potential for liquidity challenges.

First, to understand liquidity better, you also need to become familiar with the concept of working capital. It is the amount of current assets minus current liabilities. Assume that Ashcroft Company has current assets of \$1,000,000 and current liabilities of \$400,000; the working capital is \$600,000. Normally, one hopes to find that a company has a signifi- cantly positive amount of working capital. Having positive working capital can provide some comfort that the company has sufficient access to assets that are readily convertible to cash and will therefore be able to meet liabilities as they come due.

The preceding generalization is sometimes not true, however. A firm’s current assets could be invested in slow-moving inventory. These goods would be of little value in meet- ing obligations. Indeed, the obligations may have arisen upon purchase of the goods. The seller of the goods would hardly be interested in receiving them back; they expect to be paid in cash. Conversely, some businesses manage cash flow very effectively. They may provide goods and services and have little invested in inventory or receivables. A restau- rant is an excellent example.

A restaurant may have a relatively small (fresh food) inventory, and customers may all pay with cash or credit cards. The restaurant may purchase their supplies on extended credit terms. The profits and free cash flows that are generated may be constantly pulled from operations and channeled into new locations and facilities. Thus, it is not particularly rel- evant that the working capital is small (or even negative) at a particular time. Nonetheless, careful budgeting needs to be conducted to ensure that too much cash is not redirected from operations because the existing payables do need to be satisfied at some point.

How much working capital is enough? The answer to this question is partially answered by giving consideration to the issues raised in the preceding paragraphs. However, you also need to know about the size of the business. A small business may function well with \$100,000 of working capital, while a large business may run short with \$100,000,000 of working capital. Therefore, working capital is sensitive to the size of the business. You must also give consideration to the industry that a business operates in. An automobile manufacturer can be expected to have significant amounts of inventory, and this leads to an ordinary condition of a large amount of current assets and working capital. On the other hand, inventory may be totally lacking in service businesses, and they may have a much reduced level of working capital as a result.

Analysts may scale the evaluation of working capital to a ratio that relates current assets to current liabilities. The current ratio reveals the relative amount of working capital by dividing current assets by current liabilities:

Current Ratio 5 Current Assets / Current Liabilities

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CHAPTER 9Section 9.3 Liquidity Analysis

Table 9.1 lists Ashcroft’s current assets and current liabilities.

Table 9.1: Ashcroft's current assets and liabilities

Cash \$ 150,000 Accounts Payable \$ 50,000

Accounts Receivable 250,000 Wages Payable 125,000

Inventory 400,000 Interest Payable 85,000

Prepaid Assets 200,000 Taxes Payable 140,000

\$1,000,000 \$400,000

Ashcroft’s current ratio is 2.5:1 (\$1,000,0004\$400,000). This ratio does not seem to indicate any particular problem with liquidity. One thing you do need to consider is that com- panies may be able to manipulate their current ratio. For instance, suppose Ashcroft’s bank required them to maintain at least a 3:1 current ratio. Using existing resources, how could this be accomplished? The answer is easier than you might think. If Ashcroft used \$100,000 of cash to immediately pay \$100,000 of taxes payable, total current assets would be reduced to \$900,000 and total current liabilities would be reduced to \$300,000. This changes the ratio to the target of 3:1. While this might help the current ratio, it could actu- ally restrict the company’s financial flexibility by immediately forgoing part of its cash supply. Although ratios may be subject to short-term manipulation, they are nonetheless highly indicative of business performance, and this limitation should not dissuade you from proper use of these popular techniques for financial statement analysis.

It was already pointed out that current assets include inventory and prepaids that are of little use in satisfying current debts. Therefore, it is also a helpful to calculate a more stringent liquidity measure known as the quick ratio. This ratio is calculated by dividing quick assets by current liabilities. Quick assets are cash and other assets that are readily and quickly converted to cash. The latter includes short-term investments and accounts receivable. The following formula is used to calculate the quick ratio:

Quick Ratio 5 (Cash  Accounts Receivable) / Current Liabilities

Ashcroft’s quick ratio is 1:1 (\$400,000 of cash and receivables divided by \$400,000 of cur- rent liabilities). By removing the inventory and prepaids, you may gain greater insight into the ability of a firm to be truly ready to meet maturing financial obligations.

Before moving on the next category of ratios, consider that obligations that are not yet reflected as current liabilities may also be looming. Suppose the company has a contract that requires them to make monthly payments to a janitorial firm. The commitment is real, but the future services have not yet been received. Thus, neither the expense nor liability is as yet reported. Still, these types of contractual commitments may entail a firm a duty to pay and are sometimes reported in notes to the financial statements. This example provides further evidence that ratio analysis must be used with caution. An informed investor or creditor should thoroughly research not only the ratios but also all available information.

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CHAPTER 9Section 9.4 Debt Service Analysis

9.4 Debt Service Analysis

The current and quick ratios provide insight on immediate liquidity issues. There is another set of issues related to a company’s broader solvency, or the ability to satisfy long-term structural debt. Even if debt is not due to be repaid in the near term, interest payments must be made. Then, at the time of a long-term obligation’s maturity, it must be paid or refinanced. Thus, users of financial statements have developed another family of ratios and analysis techniques designed to evaluate a company’s ability to service its debt. One such ratio is the debt-to-total-assets ratio. This ratio evaluates the proportion of the asset pool that is financed with debt:

Debt-to-Total-Assets Ratio 5 Total Debt / Total Assets

A variation of this ratio is the debt-to-equity ratio that compares total debt to total equity:

Debt-to-Equity Ratio 5 Total Debt / Total Equity

Both of these ratios are carefully monitored by investors, creditors, and analysts. General- izing, it is difficult to go broke when a business has manageable debt loads, as reflected by small values for these ratios. However, comparative analysis requires careful consider- ation of the industry that a business operates in. Some industries, like public utilities, are customarily financed by large pools of debt financing. Their regulated rates are generally set at a level that is high enough to provide comfort about their debt-serving ability. This is true despite those businesses being highly leveraged with debt.

At other times, even a small amount of debt can become a problem when a business’s future looks bleak. Banks and other creditors may be interested in getting their money back and be unwilling to renew or extend debt financing that would otherwise be a rou- tine transaction. Another challenge in interpreting the ratios is when a company has a large amount of intangible assets. Those assets can be difficult or impossible to convert to cash. Nevertheless, they impact the ratio calculations in a way that paints a picture of financial health. You are likely getting the message again: Ratio analysis is helpful in assessing a company, but only when done with great care.

The times-interest-earned ratio is also used to evaluate debt service capacity. It shows how many times that a company’s income stream will cover its interest obligation:

Times-Interest-Earned Ratio 5 Income Before Income Taxes and Interest / Interest Charges

When this number drops to a small value, it signals that the company’s operating results may become insufficient to cover interest obligations. When that happens, creditors may force foreclosure of assets or other remedies that threaten the company’s ability to exist.

The following list provides facts for Brynn Corporation, followed by calculations of these key debt service indicators.

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CHAPTER 9Section 9.5 Turnover Analysis

Total assets \$800,000 Total liabilities 200,000 Total equity 600,000 Net income 60,000 Income taxes 40,000 Interest expense 20,000

Brynn’s debt-to-total-assets ratio is 0.25, calculated by dividing \$200,000 in debt by \$800,000 in assets. The debt-to-equity ratio is 0.333, calculated by dividing \$200,000 in debt by \$600,000 in equity. The times-interest-earned factor is 6, calculated as \$120,000 (income before interest and taxes: \$60,000  \$40,000  \$20,000) divided by \$20,000 in interest. You may wonder why back taxes and interest are included in calculating the lat- ter ratio. The reason is that the interest reduces both income and taxes, and knowing how many times interest can be paid before incurring those costs is wanted.

9.5 Turnover Analysis

One of the more dreadful problems a business can encounter is selling on credit and then not being able to collect amounts due. A similar problem is building up inven- tory and being unable to sell it at all. Either of these situations can eventually prove fatal to a business. Management must take great care to avoid this outcome. Both investors and creditors can sometimes get an advance hint about such problems by performing turnover analysis.

First, focus on accounts receivable. You already know that much attention is devoted to accounting for bad debts. A company must minimize bad debts by monitoring credit poli- cies, considering the credit history of potential customers, and being certain not to aban- don good sense in trying to generate all possible sales. A business should require custom- ers to prepare a credit application, check credit references, and obtain credit reports. If possible, a security deposit or bank guarantee may significantly reduce credit risk.

The collection rate must also be monitored. A large sum of money is sometimes nested in accounts receivable, and liquidity is impacted if receivables are not actively managed. The accounts-receivable-turnover ratio is a useful tool in this regard. It shows the number of times a firm’s receivables are converted to cash during a year. This tool is useful in signaling if a company is having trouble collecting receivables on a timely basis. If the turnover pace is slowing, it may signal impending collection risks or a general business slowdown. It is also helpful for comparing one business to another because it provides insight into the degree to which credit is extended and monitored. Net credit sales are divided by the average net accounts receivable:

Accounts-Receivable-Turnover Ratio 5 Net Credit Sales / Average Net Accounts Receivable

One method for finding the average net accounts receivable balance is to divide the sum of the beginning and ending receivables balances by 2. For example, assume that Zollinger had annual net credit sales of \$10,000,000, beginning accounts receivable of \$600,000, and ending accounts receivable of \$1,000,000. Zollinger’s turnover ratio is calculated as follows:

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CHAPTER 9Section 9.5 Turnover Analysis

12.5 5 \$10,000,000 / ((\$600,000  \$1,000,000) / 2)

A derivative calculation is the days outstanding ratio. It reveals how many days sales are carried in the receivables category. Zollinger’s days outstanding are 29.2, calculated as follows:

365 Days / Accounts-Receivable-Turnover Ratio 5 Days Outstanding Ratio

365 / 12.5 5 29.2

The significance of values like 12.5 or 29.2 can only be considered in context. They must be compared to industry trends and prior years as well as credit terms used by the company. Changes in values may provide signs of looming problems, such as a weakening economy or bad business decision making.

Inventory-turnover ratios are very similar in nature. Inventory is expensive and subject to obsolescence, damage, and spoilage. It is costly to store and involves a potentially huge commitment of financial capital. It is a delicate balance to maintain levels to adequately support key customers but avoid overstock. Equilibrium in inventory levels is delicate and easily lost. The inventory-turnover ratio is used to maintain focus on proper inven- tory management and to signal failings in this regard. This ratio reveals the number of times that a firm’s inventory balance is turned over or sold during a particular year.

For example, The Home Depot turns its inventory about six to seven times per year, which is a turnover ratio of 6 to 7. This means the “average” item of inventory will sit on the shelf for slightly less than 60 days before finding a buyer. By itself, this datum is interesting but, when used to compare activity from year to year, it can signal improving or worsening economic conditions. It can also be compare to other companies, like Lowes, which has a slightly lower inventory turnover ratio of 5 to 6. In other words, The Home Depot usually turns it inventory faster than Lowes. The inventory-turnover ratio is calculated via the following formula:

Inventory-Turnover Ratio 5 Cost of Goods Sold / Average Inventory

Notice that this calculation bears a striking resemblance to the accounts-receivable- turnover ratio. The average inventory balance can be found by dividing the sum of the beginning and ending inventory balances by 2. When a company’s average inventory is \$2,500,000 and cost of goods sold is \$25,000,000, the inventory turnover ratio is 10. This means that the inventory stock is turning over about once every 36.5 days (365 divided by 10). The meaningfulness of this information must again be considered in context. A car dealer might be very pleased with this number, whereas a vegetable supplier might find this to be disastrously poor. Probably more important than fixating on the value is to observe the trend in this number. The objective is to detect emerging challenges that might be signified by changes in these numbers. Further, if you are comparing inventory- turnover ratios for competing firms, be sure to note that the choice of inventory methods (e.g., FIFO vs. weighted average) can cause distortions in comparative analysis.

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208

CHAPTER 9Section 9.6 Profitability Analysis

9.6 Profitability Analysis

Investors are especially interested in knowing that businesses that they invest in are capable of producing an eventual profit. As a very broad generalization (and therefore subject to many exceptions), the more profitable a firm is, the more valuable it is. Owning 10% of a business making a total profit of \$1,000,000, rather than 1% of a business mak- ing \$2,000,000 in profits, is more desirable. Thus, it is necessary to evaluate profitability not only in the aggregate but also on a scale, or ratio, basis. There are many ways to perform profit analysis. To begin, two key ratios are the gross-profit-margin ratio and net-profit-margin ratio:

Gross-Profit-Margin Ratio 5 Gross Profit / Net Sales

Net-Profit-Margin Ratio 5 Net Income / Net Sales

Both ratios examine profitability in relation to sales. The gross-profit-margin ratio exam- ines the proportion of sales that is leftover after taking into account only the cost of the units sold. This proportion is then used to absorb selling, general, and administrative costs. The net-profit-margin ratio reflects the final residual amount. If Mega Corpora- tion had sales of \$5,000,000, cost of goods sold of \$2,000,000, and net income of \$500,000, its gross profit margin would be 60% [(\$5,000,000 2 \$2,000,000)4\$5,000,000], and its net profit margin would be 10% (\$500,0004\$5,000,000). As you can see, calculating these two ratios is very simple and based on information prominently appearing on the income statement. Comparing profits rates over time and across companies is perhaps among the most common form of financial statement analysis. Both rates are important to monitor because they provide signals about business scalability and sustainability, regardless of firm size. (These issues are examined in more detail in a managerial accounting course.)

Another way to examine profitability is to compare profits to invested assets and equity. Here, the goal is to compute how effectively assets and equity are being used to generate profits. The return-on-assets (ROA) ratio is calculated by dividing income before inter- est cost by the average assets used in the business:

Return-on-Assets Ratio 5 (Net Income  Interest Expense) / Average Assets

The ROA ratio is an attempt to focus attention on the amount of income, before financing costs, that is generated by the business’s assets. In other words, looking at how much the assets earned, exclusive of what it costs to finance them. In some ways, this reflects man- agement’s stewardship and skill at using business assets in an effective and efficient way. The next ratio looks at net income in comparison to invested capital and takes into account the business’s financing costs.

The return-on-equity (ROE) ratio evaluates income in relation to the amount of invested common shareholder equity:

Return-on-Equity Ratio 5 Net Income / Average Common Equity

The ROE ratio evaluates management effectiveness at using shareholder equity. The ratio implicitly recognizes that a business might borrow substantial funds to acquire assets and deploy those assets to earn at a rate that is higher (positive leverage) or lower (negative

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CHAPTER 9Section 9.7 Other Measures

leverage) than the cost of borrowed funds. In other words, leverage relates to the use of borrowed fund in an attempt to amplify returns to owner-provided capital. To the extent that a business decides to use debt to finance assets, it becomes very important to assess how effective that decision is, and the ROE ratio provides a signal about that effort.

There are alternative theories about the best ways in which to calculate ROA and ROE ratios, but they all share the same goal. The goal is to assess management’s stewardship (i.e., ability to generate returns) with respect to assets and equity; in particular, it provides a basis for knowing whether debt is being managed in a way that is accretive or dilutive to the shareholders’ best interests. One hopes to find that the ROE ratio is at least equal to and hopefully greater than the ROA ratio.

The summary illustration at the end of this chapter shows complete data sufficient to cal- culate both ratios. When you review that, be sure to take note that the ROE ratio is greater than the ROA ratio. This means that the company is using its borrowing effectively to increase overall firm earnings. If the company had instead relied solely on equity financ- ing for its assets, the overall rate of return on shareholder investments would be lower.

9.7 Other Measures

In the preceding discussion on profitability analysis, you were cautioned that evalua-tions of profitability need to take into account the firm size. Public corporations are those that have shares of stock that are easily bought and sold by individual investors over organized stock exchanges such as the NYSE or NASDAQ. Publicly traded compa- nies are required to present earnings-per-share (EPS) information. This is perhaps the most popular “scaled” profitability measure. It allows investors to compare the income of a large corporation having hundreds of millions of shares to the income of a smaller company having perhaps less than 1 million shares of stock. The larger company would perhaps produce a greater amount of overall profit, but it is possible that the smaller com- pany might be doing better on an EPS basis.

EPS data is widely followed. Press releases and business news outlets focus heavily on this number, often comparing actual EPS to projected EPS. Because stock is priced on a per-share basis, it is only logical to expect that earnings are also monitored on a per- share basis. This number is important, but you should be careful not to fixate on a single indicator. EPS data often includes the impacts of nonrecurring transactions and events. A detailed income statement will usually include operating details about income from con- tinuing operations, segregated from the effects of other special events impacting income. Similarly, EPS data is often subdivided into special components, and one must look very closely at the specific composition of each period’s EPS data.

In its simplest form, EPS data is just a fraction determined by dividing income by the number of shares outstanding. EPS can be calculated based on any time period but is most often reported on a quarterly and annual basis. One potential complication arises when the number of shares of stock changes during a period. For instance, a company may issue additional shares during the period, in which case the EPS calculation is based on the weighted-average shares outstanding for the period (not the number outstanding at the end of the period). The following formula summarizes the basic mathematics for simple EPS:

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CHAPTER 9Section 9.7 Other Measures

Income Available to Common Shares / Weighted-Average Number of Common Shares

To illustrate, assume that Brooklyn Corporation had an annual net income of \$2,400,000. Brooklyn started the calendar year with 600,000 shares outstanding but issued an addi- tional 300,000 shares for cash on May 1. The EPS is \$3. Determining this value begins with calculating the weighted-average number of shares outstanding. Brooklyn had 600,000 shares outstanding for the first 4 months of the year (or one third of the year) and 900,000 shares outstanding for the last 8 months of the year (or two thirds of the year). Thus,

Weighted-Average Number of Shares 5 800,000 [600,000  (143)]  [900,000  (243)]

and the EPS is calculated as \$2,400,000 / 800,000 shares.

EPS calculations can quickly grow cumbersome. Later, you will learn that a company may have several types of capital stock. Some shares are called common stock, and other shares may be designated as preferred stock. Common stock is the residual interest in the business. Preferred stock has some advantages, usually in the form of a guaranteed dividend and liquidation preferences. As such, it has first claims on earnings up to the amount of a stated dividend rate. Common shares only stand to benefit to the extent that earnings exceed the preferential dividend. To be more technically precise, EPS is really earnings available per common share. Thus, the proper formulation of calculating EPS would really consist of net income minus any preferred dividends.

The “basic” EPS number may be all that a company is required to report. At other times, a complex company may find it necessary to also report a diluted EPS amount. Some companies may have issued more exotic financial instruments, such as options on stock or debt that can be converted into stock. When this condition is encountered, accountants are required to assess the potential effect on EPS, as if the options were exercised and conver- sion occurred. When the hypothetical issuance of additional shares causes a reduction (a dilution) in EPS, it typically becomes required to report this second EPS measure. The idea of this expanded reporting is to alert shareholders to the impacts on EPS of the potential issue of additional shares.

If you have even a passing familiarity with stock investing, you probably have some knowledge of the price-to-earnings (P/E) ratio. This number is often reported in ana- lysts’ reports and even in newspaper listings of stock prices. As its name suggests, the P/E ratio is calculated as follows:

Price-to-Earnings Ratio 5 Market Price per Share / Earnings per Share

If a stock is currently selling at \$25 per share and has an EPS of \$2, then its P/E ratio would be 12.5. Low P/E ratios are sometimes indicators of good investment values and vice versa, but this is not always the case. As already noted, earnings measures are subject to nonrecurring distortions of long-term trends. Further, some businesses may be underper- forming in the near term but have excellent long-term prospects. Think of the P/E ratio like a pulse rate; the same person can have a fluctuating pulse based on his or her current status (sleeping, running, etc.), and a full assessment of health requires knowledge of that status. Only a negligent doctor would prescribe a treatment plan based solely on a pulse rate. A similar comparison can be made to investment decisions tied only to the P/E ratio.

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CHAPTER 9Section 9.8 Recap and Summary Illustration

Not all companies pay dividends. Some companies may prefer to reinvest earnings to expand business operations. For many years, Apple did not pay dividends, choosing instead to reinvest in new product development. Other businesses may not have sufficient earnings to support dividends. But, mature businesses may generate more than enough cash to support ongoing business needs, and those companies will often return profits to shareholders. In recent years, Apple’s successful products were so profitable that the company accumulated an abundance of cash and began to pay dividends.

Another number that you might wish to calculate is the dividend rate. This number is also known as the dividend yield and is determined by dividing the annual cash dividend by the market price per share of the stock.

Assume that Delta Company pays annual dividends of \$0.40 per share. If its stock sells for \$8.00 per share, the yield would be 5% (\$0.404\$8.00). Investors may wonder if Delta can sustain this dividend rate. To make this assessment, they would likely examine the Delta’s dividend history and cash supply. These two factors may help predict the future dividend stream. However, it is also important to make sure that ongoing operations can continue to support the dividend. Thus, the dividend payout rate should also be calculated. Its value is determined by dividing the annual cash dividend by the EPS. If Delta earned \$1.00 per share, its payout ratio is 0.40 (\$0.404\$1.00).

Investors may also look at the book value per share. This is the amount of stockhold- ers’ equity represented by each share of common stock. You should be extremely care- ful in thinking about book value per share. It is based on the reported amount of stock- holders’ equity. Remember the fundamental accounting equation: Assets 5 Liabilities  Equity. Many assets are listed at their cost, not their value. This is a double-edged sword. Some assets may be worth more than their cost and vice versa. This is especially true for recorded and unrecorded intangible assets. Thus, the residual reported equity may not be very reflective of the intrinsic firm value, and calculations of book value per share may be far afield from what the stock would be valued at on a per-share basis. Nevertheless, it is a popular measure. Some investors look to this number as the floor price below which the stock is seen as a bargain. You are cautioned against jumping to this conclusion.

As with EPS, book value is a per share of common stock concept. For companies with complex capital structures involving preferred stocks, stock options, convertible securi- ties, and so forth, a number of adjustments may be necessary. Because book value per share is a number that is calculated by analysts (i.e., it is not reported by the company’s accountants), there is no generally accepted accounting principle that describes exactly how those adjustments should occur. Generalizing, the idea is to distill the total equity down to a hypothetical amount that would remain after liquidating all noncommon share interests in the company. The remaining equity is then divided by the number of common shares outstanding to find the book value per share of common stock.

9.8 Recap and Summary Illustration

Many new concepts were introduced in this chapter. Table 9.2 summarizes the various ratios and calculations that you were exposed to. The final column includes typical acceptable values for the indicated ratios. However, as noted throughout the chapter, it is impossible to stipulate universal generalizations for the values of these ratios, and the last column should not be given undue weightings. Each situation can vary.

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CHAPTER 9Section 9.8 Recap and Summary Illustration

Table 9.2: Ratios and calculations Liquidity Current Ratio Current Assets / Current

Liabilities A measure of liquidity; the ability to meet near-term obligations

2:1 or greater

Quick Ratio (Cash  Short-Term Investments  Accounts Receivable) / Current Liabilities

A narrow measure of liquidity; the ability to meet near-term obligations

1.25:1 or greater

Debt Service Debt-to-Total- Assets Ratio

Total Debt / Total Assets Percentage of assets financed by long-term and short-term debt

0.5 or less

Debt-to-Equity Ratio

Total Debt / Total Equity Proportion of financing that is debt related

1:1 or less

Times-Interest- Earned Ratio

Income Before Income Taxes and Interest / Interest Charges

Ability to meet interest obligations

8 or higher

Turnover Ratios Accounts- Receivable- Turnover Ratio

Net Credit Sales / Average Net Accounts Receivable

Frequency of collection cycle; to monitor credit policies

9 or higher

Inventory- Turnover Ratio

Cost of Goods Sold / Average Inventory

Frequency of inventory rotation; to monitor inventory management

6 or higher

Profitability Ratios Gross-Profit- Margin Ratio

Gross Profit / Net Sales Gross profit rate; for comparison and trend analysis

50% or higher

Net-Profit- Margin Ratio

Net Income / Net Sales Profitability on sales; for comparison and trend analysis

5% or higher

Return-on-Assets Ratio

(Net Income  Interest Expense) / Average Assets

Asset utilization in producing returns

10% or higher

Return-on-Equity Ratio

Net Income / Average Common Equity

Effectiveness of equity investment in producing returns

10% or higher

Other Measures Earnings per Share

Income Available to Common / Weighted-Average Number of Common Shares

Amount of earnings attributable to each share of common stock

Positive and increasing over time

Price-to-Earnings Ratio

Market Price per Share / Earnings Per Share

The price of the stock in relation to earnings per share

15 or lower

Dividend Yield Annual Cash Dividend / Market Price per Share

Direct yield to investors through dividend payments

2.5% or higher

Dividend Payout Rate

Annual Cash Dividend / Earnings per Share

Proportion of earnings distributed as dividends

40% or less

Book Value per Share

“Common” Equity / Common Shares Outstanding

The amount of stockholders’ equity per common share outstanding

Positive and increasing over time

Exhibit 9.7 shows comprehensive financial statements for Mossman Company. This infor- mation will be used to demonstrate the calculation of all ratios introduced in this chapter, as shown in Table 9.3. The value of Mossman’s stock was \$20 per share throughout the year, and there were 500,000 shares outstanding. All sales were on account.

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213

CHAPTER 9Section 9.8 Recap and Summary Illustration

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214

CHAPTER 9Section 9.8 Recap and Summary Illustration

Table 9.3: Calculation of ratios

Current Ratio Current Assets / Current Liabilities \$2,600,0004\$1,240,000 5 2.1

Quick Ratio (Cash  Short-Term Investments  Accounts Receivable) / Current Liabilities

\$2,400,0004\$1,240,000 5 1.94

Debt-to-Total- Assets Ratio

Total Debt / Total Assets \$1,965,0004\$4,600,000 5 0.43

Debt-to-Equity Ratio

Total Debt / Total Equity \$1,965,0004\$2,635,000 5 0.75

Times-Interest- Earned Ratio

Income Before Income Taxes and Interest / Interest Charges

\$ 1,240,0004\$48,000 5 26

Accounts- Receivable- Turnover Ratio

Net Credit Sales / Average Net Accounts Receivable

\$ 3,000,0004\$575,000 5 5.2

Inventory-Turnover Ratio

Cost of Goods Sold / Average Inventory

\$ 1,160,0004\$187,500 5 6.2

Net-Profit-Margin Ratio

Net Income / Net Sales \$ 770,0004\$3,000,000 5 26%

Gross-Profit-Margin Ratio

Gross Profit / Net Sales \$1,840,0004\$3,000,000 5 61%

Return-on-Assets Ratio

(Net Income + Interest Expense) / Average Assets

\$ 818,0004\$4,307,500 5 19%

Return-on-Equity Ratio

(Net Income - Preferred Dividends)/ Average Common Equity

\$ 770,0004\$2,275,000 5 34%

Earnings per Share Income Available to Common / Weighted-Average Number of Common Shares

\$ 770,0004500,000 5 \$1.54

Price-to-Earnings Ratio

Market Price per Share / Earnings per Share

\$ 204\$1.54 5 13

Dividend Yield Annual Cash Dividend / Market Price per Share

\$ 0.104\$20 5 0.5%

Dividend Payout Rate

Annual Cash Dividend / Earnings per Share

\$ 0.104\$1.54 5 6.5%

Book Value per Share

“Common” Equity / Common Shares Outstanding

\$ 2,635,0004500,000 5 \$5.27

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215

CHAPTER 9

accounts-receivable-turnover ratio The number of times a firm’s receivables are converted to cash during a year: Accounts- Receivable-Turnover Ratio 5 Net Credit Sales / Average Net Accounts Receivable.

book value per share The amount of stockholders’ equity represented by each share of common stock.

common-size financial statement Relates to scaling the dollar amounts within finan- cial statements to percentage terms.

current ratio Reveals the relative amount of working capital by dividing current assets by current liabilities: Current Ratio 5 Current Assets / Current Liabilities.

Key Terms

Concept Check

The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)

1. Vertical analysis a. cannot be used to compare companies of different size. b. provides information about the magnitude, direction, and relative importance of

changes in individual financial statement items. c. is needed to assess the coverage of obligations. d. results in common size financial statements.

2. London Corporation paid \$1,000 of accounts payable with cash on the last day of the month. The company had a current ratio of 4 before the disbursement. As a result of this payment, the current ratio will a. increase. b. decrease. c. remain unchanged. d. fluctuate, but the direction of the change depends on unstated facts.

3. Jedd Inc. has obtained long-term debt at a 14% interest rate and is achieving a return on assets of 42%. These figures indicate that Jedd will have a. a 28% increase in earnings per share, b. a 28% increase in the profit margin on sales, c. a return on common stockholders’ equity of less than 14%. d. a return on common stockholders’ equity of more than 14%.

4. Annual reports a. are issued to corporate managers but not to stockholders. b. contain a corporation’s financial statements, accompanying notes, and various

other management disclosures. c. contain a corporation’s financial statements but not the auditor’s report. d. focus more on marketing the corporation’s products than on disclosing financial

information.

Key Terms

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216

CHAPTER 9Key Terms

days sales outstanding ratio Reveals how many days sales are carried in the receivables category: Days Outstanding 5 365 Days / Accounts-Receivable-Turnover Ratio.

debt-to-equity ratio Compares total debt to total equity: Debt-to-Equity Ratio 5 Total Debt / Total Equity.

debt-to-total-assets ratio Evaluates the proportion of the asset pool that is financed with debt: Debt-to-Total-Assets Ratio 5 Total Debt / Total Assets.

dividend payout rate A value that is determined by dividing the annual cash dividend by earnings per share.

dividend yield A value that is determined by dividing the annual cash divided by the market price per share of the stock.

earnings per share (EPS) Allows investors to compare the income of a large corpora- tion having hundreds of millions of shares of stock: Income Available to Common Shares / Weighted-Average Number of Common Shares.

EPS See earnings per share.

gross-profit-margin ratio Examines the proportion of sales that is leftover, taking into account only the cost of the units sold: Gross Profit / Net Sales.

horizontal analysis Used to compare data from two or more periods, side-by-side.

inventory-turnover ratio Reveals the number of times that a firm’s inventory balance is turned over or sold during a particular year: Inventory-Turnover Ratio 5 Cost of Goods Sold / Average Inventory.

liquidity The ability to meet near-term obligations as they mature.

net-profit-margin ratio Reflects the final residual amount: Net Profit on Sales 5 Net Income / Net Sales.

P/E ratio See price-to-earnings ratio.

price-to-earnings (P/E) ratio A printabil- ity ratio that examines an organization's success during an accounting period. Price Earnings Ratio5 Market Price per Share / Earnings per Share.

quick ratio A stringent liquidity that is calculated by dividing “quick assets” by current liabilities: Quick Ratio 5 (Cash  Short-Term Investments + Accounts Receivable) / Current Liabilities.

return-on-assets (ROA) ratio Measures profitability from a given level of asset investment. Calculated by dividing income before interest cost by the average assets used in the business: Return-on-Assets Ratio 5 (Net Income  Interest Expense) / Average Assets.

return-on-equity (ROE) ratio Evalu- ates income in relation to the amount of invested common shareholder equity: Return-on-Equity Ratio 5 Net Income / Average Common Equity.

ROA See return-on-assets ratio.

ROE See return-on-equity ratio.

solvency The ability to satisfy a long-term structural debt.

times-interest-earned ratio Shows how many times a company’s income stream will cover its interest obligation: Times- Interest-Earned Ratio 5 Income Before Income Taxes and Interest / Interest Charges.

vertical analysis Results when each expense category is expressed as a percent- age of sales.

working capital The amount of current assets minus current liabilities.

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217

CHAPTER 9Exercises

Critical Thinking Questions

1. Distinguish between horizontal analysis and vertical analysis. Which type of analy- sis results in common-size financial statements?

2. What is one of the basic benefits associated with the use of common-size financial statements?

3. A student once noted, “This ratio stuff is great. It’s unbelievable how ratios can tell the complete story behind the problems of a business.” Comment on the student’s observation.

4. Briefly describe the following types of ratios and identify the financial statement users most interested in each type. a. Liquidity ratios b. Activity ratios c. Profitability ratios d. Coverage ratios

5. What is the current ratio? Present a short critique of this widely used financial measure.

6. Why do many analysts prefer the quick ratio over the current ratio for judging debt-paying ability?

7. What insight can be provided by the accounts-receivable-turnover ratio? The inventory-turnover ratio?

8. Discuss the differences between the return on assets and the return on common stockholders’ equity.

9. Briefly explain how the price-to-earnings ratio gives insights about investor attitudes.

Exercises

1. Horizontal analysis. Mary Lynn Corporation has been operating for several years. Selected data from the 20X1 and 20X2 financial statements follow.

20X2 20X1

Current Assets \$ 76,000 \$ 80,000

Property, Plant, and Equipment (net) 99,000 90,000

Intangibles 25,000 50,000

Current Liabilities 40,800 48,000

Long-Term Liabilities 143,000 160,000

Stockholders’ Equity 16,200 12,000

Net Sales 500,000 500,000

Cost of Goods Sold 332,500 350,000

Operating Expenses 93,500 85,000

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218

CHAPTER 9Exercises

Prepare a horizontal analysis for 20X1 and 20X2. Briefly comment on the results of your work.

2. Vertical analysis. Study the data pertaining to Mary Lynn Corporation that appear in Exercise 1. Prepare a vertical analysis for 20X1 and 20X2 and briefly evaluate the results of your work.

3. Liquidity ratios. Edison, Stagg, and Thornton have the following financial infor- mation at the close of business on July 10:

Edison Stagg Thornton

Cash \$4,000 \$2,500 \$1,000

Short-Term Investments 3,000 2,500 2,000

Accounts Receivable 2,000 2,500 3,000

Inventory 1,000 2,500 4,000

Prepaid Expenses 800 800 800

Accounts Payable 200 200 200

Notes Payable: Short-Term 3,100 3,100 3,100

Accrued Payables 300 300 300

Long-Term Liabilities 3,800 3,800 3,800

a. Compute the current and quick ratios for each of the three companies. (Round calculations to two decimal places.) Which firm is the most liquid? Why?

b. Suppose Thornton is using FIFO for inventory valuation and Edison is using LIFO. Comment on the comparability of information between these two companies.

c. If all short-term notes payable are due on July 11 at 8 a.m., comment on each company’s ability to settle its obligation in a timely manner.

4. Computation and evaluation of activity ratios. The following data relate to Alaska Products Inc.:

20X5 20X4

Net Credit Sales \$832,000 \$760,000

Cost of Goods Sold 440,000 350,000

Cash, Dec. 31 125,000 110,000

Accounts Receivable, Dec. 31 180,000 140,000

Inventory, Dec. 31 70,000 50,000

Accounts Payable, Dec. 31 115,000 108,000

The company is planning to borrow \$300,000 via a 90-day bank loan to cover short- term operating needs.

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219

CHAPTER 9Exercises

a. Compute the accounts-receivable and inventory-turnover ratios for 20X5. Alaska rounds all calculations to two decimal places.

b. Study the ratios from part (a) and comment on the company’s ability to repay a bank loan in 90 days.

c. Suppose that Alaska’s major line of business involves the processing and distri- bution of fresh and frozen fish throughout the United States. Do you have any concerns about the company’s inventory-turnover ratio? Briefly discuss.

5. Profitability ratios, trading on the equity. Digital Relay has both preferred and com- mon stock outstanding. The company reported the following information for 20X7:

Net sales \$1,500,000 Interest Expense 120,000 Income Tax Expense 80,000 Preferred Dividends 25,000 Net Income 130,000 Average Assets 1,100,000 Average Common Stockholders’ Equity 400,000

a. Compute the net-profit-margin ratio and the rates of return on assets and com- mon stockholders’ equity, rounding calculations to two decimal places.

b. Does the firm have positive or negative financial leverage? Briefly explain.

6. Evaluation of selected ratios. Selected ratios of Glenwood Power Equipment Company and averages for the power equipment industry follow:

Glenwood Industry Current ratio 2.21 1.63 Average collection period of receivables

39 days 21 days

Inventory turnover 4.1 1.9 Net-profit-margin 7.0% 8.8% Return on assets 10.0% 9.5% Debt-to-total assets 31.7% 39.8%

Evaluate these ratios and determine whether you agree or disagree with the follow- ing statements:

a. Glenwood has better debt-paying ability than the “average” company in the power equipment industry.

b. Glenwood is performing below average in managing its inventories. c. The amount of income generated, given the company’s resources, exceeds that

produced by the industry. d. Glenwood may need to improve its management of credit and customer collections. e. In view of the company’s revenues, Glenwood’s ability to produce earnings is

significantly below the industry norm.

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220

CHAPTER 9Problems

Problems

1 Horizontal and vertical analysis. The following financial statements pertain to Waterloo Corporation:

WATERLOO CORPORATION Comparative Balance Sheets December 31,20X5 and 20X4

20X5 20X4

Assets

Current Assets

Cash \$ 11,250 \$ 12,500

Accounts Receivable (net) 18,500 25,000

Inventories 38,500 35,000

Prepaid Expense 3,750 3,750

Total Current Assets \$ 72,000 \$ 76,250

Property, Plant, and Equipment

Buildings (net) \$ 102,750 \$ 101,250

Equipment (net) 28,500 30,000

Vehicles (net) 32,000 40,000

Total Property, Plant, and Equipment \$ 163,250 \$ 171,250

Trademarks (net) \$ 14,750 \$ 2,500

Total assets \$ 250,000 \$ 250,000

Liabilities and Stockholders’ Equity

Current Liabilities

Accounts Payable \$ 49,000 \$ 70,000

Notes Payable 13,500 40,000

Federal Taxes Payable 2,500 25,000

Total Current Liabilities \$ 65,000 \$ 135,000

Long-Term Debt \$ 50,000 \$ 25,000

Total Liabilities \$ 115,000 \$ 160,000

Stockholders’ Equity

Common Stock, \$10 par \$ 25,000 \$ 25,000

Retained Earnings 110,000 65,000

Total Stockholders’ Equity \$ 135,000 \$ 90,000

Total Liabilities and Stockholders’ Equity \$ 250,000 \$ 250,000

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221

CHAPTER 9Problems

WATERLOO CORPORATION Comparative Income Statements

For the Years Ending December 31, 20X5 and 20X4

20X5 20X4 Net Sales \$ 550,000 \$500,000 Cost of Goods Sold 330,000 250,000 Gross Profit \$ 220,000 \$250,000 Operating Expense 132,500 100,000 Income Before Interest and Taxes \$ 87,500 \$150,000 Interest Expense 12,500 3,000 Income Before Taxes \$ 75,000 \$147,000 Income Tax Expense 30,000 58,800 Net Income \$ 45,000 \$ 88,200

Instructions a. Prepare a horizontal analysis of the balance sheet, showing dollar and percentage

changes. Round all calculations in parts (a) and (b) to two decimal places. b. Prepare a vertical analysis of the income statement by relating each item to net sales. c. Briefly comment on the results of your analysis.

2. Ratio computation. The financial statements of the Lone Pine Company follow.

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222

CHAPTER 9Problems

LONE PINE COMPANY Comparative Balance Sheets

December 31, 20X2 and 20X1 (\$000 Omitted) 20X2 20X1

Assets Current Assets Cash and Short-Term Investments \$ 400 \$ 600 Accounts Receivable (net) 3,000 2,400 Inventories 2,000 2,200

Total Current Assets \$5,400 \$5,200 Property, Plant, and Equipment Land \$1,700 \$ 600 Buildings and Equipment (net) 1,500 1,000

Total Property, Plant, and Equipment \$3,200 \$1,600 Total Assets \$8,600 \$6,800 Liabilities and Stockholders’ Equity Current Liabilities Accounts Payable \$1,800 \$1,700 Notes Payable 1,100 1,900

Total Current Liabilities \$2,900 \$3,600 Long-Term Liabilities Bonds Payable 4,100 2,100

Total Liabilities \$7,000 \$5,700 Stockholders’ Equity Common Stock \$ 200 \$ 200 Retained Earnings 1,400 900

Total Stockholders’ Equity \$1,600 \$1,100 Total Liabilities and Stockholders’ Equity \$8,600 \$6,800

LONE PINE COMPANY Statement of Income and Retained Earnings

For the Year Ending December 31,20X2 (\$000 Omitted) Net Sales* \$36,000 Less: Cost of Goods Sold \$20,000 Selling Expense 6,000 Administrative Expense 4,000 Interest Expense 400 Income Tax Expense 2,000 32,400

Net Income \$ 3,600 Retained Earnings, Jan. 1 900

\$ 4,500 Cash Dividends Declared and Paid 3,100 Retained Earnings, Dec. 31 \$ 1,400 *All sales are on account.

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CHAPTER 9Problems

Instructions Compute the following items for Lone Pine Company for 20X2, rounding all calcu- lations to two decimal places when necessary:

a. Quick ratio b. Current ratio c. Inventory-turnover ratio d. Accounts-receivable-turnover ratio e. Return-on-assets ratio f. Net-profit-margin ratio g. Return-on-common-stockholders’ equity h. Debt-to-total assets i. Number of times that interest is earned j. Dividend payout rate

3. Financial statement construction via ratios. Incomplete financial statements of Lock Box Inc. are presented as follows:

LOCK BOX INC. Income Statement

For the Year Ending December 31, 20X3 Sales \$ ? Cost of Goods Sold ? Gross Profit \$ 15,000,000 Operating Expenses and Interest ? Income Before Taxes \$ ? Income taxes, 40% ? Net income \$ ?

LOCK BOX, INC. Balance Sheet

December 31, 20X3 Assets

Cash \$ ? Accounts Receivable ? Inventory ? Property, Plant, and Equipment 8,000,000 Total assets \$ 24,000,000

Liabilities and Stockholders’ Equity Accounts Payable \$ ? Notes Payable: Short-Term 600,000 Bonds Payable 4,600,000 Common Stock 2,000,000 Retained Earnings ? Total Liabilities and Stockholders’ Equity \$ 24,000,000

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CHAPTER 9Problems

Further information is the following:

• Cost of goods sold is 60% of sales. All sales are on account. • The company’s beginning inventory is \$5 million; inventory-turnover ratio is 4. • The debt-to-total-assets ratio is 70%. • The profit margin on sales is 6%. • The firm’s accounts-receivable-turnover ratio is 5. Receivables increased by

\$400,000 during the year.

Instructions Using the preceding data, complete the income statement and the balance sheet.

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