In a narrative format, discuss the importance of using financial ratios.

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Reviewing Financial Statements

PART TWO

Business Application The managers of DPH Tree Farm, Inc., believe the firm could double its sales if it had additional factory space and acreage. If DPH purchased the factory space and acreage in 2013, these new assets would cost $27 million to build and would require an additional $1 million in cash, $5 million in accounts receivable, $6 million in inventory, and $4 million in accounts payable. In addition to accounts payable, DPH Tree Farm would finance the new assets with the sale of a combination of long-term debt (40 percent of the total) and common stock (60 percent of the total). Assuming all else stays constant, what will these changes do to DPH Tree Farm’s 2013 balance sheet assets, liabilities, and equity? (See 2012 balance sheet on p. 35) (See solution on p. 52)

Personal Application Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm’s annual report but is not sure how to read them or what they mean. What are the four financial statements that Chris should pay most attention to? What information will these key financial statements contain? (See solution on p. 52)

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LGLLG LG learning goals LG1 Recall the major finan-

cial statements that firms must prepare and provide.

LG2 Differentiate between book (or accounting) value and market value.

LG3 Explain how taxes influence corporate managers’ and inves- tors’ decisions.

LG4 Differentiate between accounting income and cash flows.

LG5 Demonstrate how to use a firm’s financial statements to calculate its cash flows.

LG6 Observe cautions that should be taken when examining financial statements.

C orporate managers must issue many reports to the public. Most stockholders, analysts, government entities, and other interested parties pay particular attention to annual reports. An annual report provides four basic financial statements: the balance sheet, the income state- ment, the statement of cash flows, and the statement of retained earnings. A financial statement provides an accounting-based picture of a firm’s financial position.

Whereas accountants use reports to present a picture of what happened in the past, finance professionals use financial statements to draw inferences about the future. The four statements function to provide key information to managers, who make financial decisions, and to investors, who will accept or reject possible future investments in the firm. When you encountered these four financial statements in accounting classes, you learned how they func- tion to place the right information in the right places. In this chapter, you will see how understanding these statements, which are the “right places” for crucial information, creates a solid base for your understanding of decision- making processes in managerial finance.

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34 part two Financial Statements

This chapter examines each statement to clarify its major features and uses. We highlight the differences between the accounting-based (book) value of a firm (reflected in these statements) and the true market value of a firm, which we will come to understand more fully. We also make a clear distinction between accounting-based income and actual cash flows, a topic further explored in Chapter 3, where we see how important cash flows are to the study of finance.

We also open a discussion in this chapter about how firms choose to repre- sent their earnings. We’ll see that managers have substantial discretion in pre- paring their firms’ financial statements, depending on strategic plans for the organization’s future. This is worth looking into as we keep the discipline of finance grounded in a real-world context. Finally, leading into Chapter 3, we discuss some cautions to bear in mind when reviewing and analyzing financial statements.

2.1 ∣ Balance Sheet The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time. It is a picture of the assets the firm owns and who has claims on these assets as of a given date, for example, December 31, 2012. A firm’s assets must equal (balance) the liabilities and equity used to purchase the assets (hence the term balance sheet ):

Assets 5 Liabilities 1 Equity (2-1)

Figure 2.1 illustrates a basic balance sheet and Table 2.1 presents a simple balance sheet for DPH Tree Farm, Inc., as of December 31, 2012 and 2011. The left side of the balance sheet lists assets of the firm and the right side lists liabilities and equity. Both assets and liabilities are listed in descending order of liquidity, that is, the time and effort needed to convert the accounts to cash. The most liquid assets—called current assets —appear first on the asset side of the balance sheet. The least liquid, called fixed assets, appear last. Similarly, current liabilities—those obligations that the firm must pay within a year—appear first on the right side of the balance sheet. Stockholders’ equity, which never matures, appears last on the balance sheet.

Assets Figure 2.1 shows that assets fall into two major categories: current assets and fixed assets. Current assets will normally convert to cash within one year. They include cash and marketable securities (short-term, low-rate investment secu- rities held by the firm for liquidity purposes), accounts receivable, and inventory. Fixed assets have a useful life exceeding one year. This class of assets includes physical (tangible) assets, such as net plant and equipment, and other, less tan- gible, long-term assets, such as patents and trademarks. We find the value of net plant and equipment by taking the difference between gross plant and equip- ment (or the fixed assets’ original value) and the depreciation accumulated against the fixed assets since their purchase.

Liabilities and Stockholders’ Equity Lenders provide funds, which become liabilities, to the firm. Liabilities fall into two categories as well: current or long-term. Current liabilities constitute the firm’s obligations due within one year, including accrued wages and taxes,

financial statement

Statement that provides an accounting-based pic- ture of a firm’s financial position.

LG1

balance sheet

The financial statement that reports a firm’s assets, liabilities, and equity at a particular point in time.

liquidity

The ease of conversion of an asset into cash at a fair value.

current assets

Assets that will normally convert to cash within one year.

marketable securities

Short-term, low-rate invest- ment securities held by the firm for liquidity purposes.

fixed assets

Assets with a useful life exceeding one year.

liabilities

Funds provided by lenders to the firm.

current liabilities

Obligations of the firm that are due within one year.

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chapter 2 Reviewing Financial Statements 35

accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with maturities of more than one year.

The difference between total assets and total liabilities of a firm is the stockholders’ (or owners’) equity. The firm’s preferred and common stock owners provide the funds known as stockholders’ equity. Preferred stock is a hybrid security that has characteristics of both long-term debt and com- mon stock. Preferred stock is similar to common stock in that it represents an ownership interest in the issuing firm but, like long-term debt, it pays a fixed periodic (dividend) payment. Preferred stock appears on the balance sheet as the cash proceeds when the firm sells preferred stock in a public offering. Common stock and paid-in surplus is the fundamental owner- ship claim in a public or private company. The proceeds from common stock and paid-in surplus appear as the other component of stockholders’ equity. If the firm’s managers decide to reinvest cumulative earnings rather than pay the dividends to stockholders, the balance sheet will record these funds as retained earnings.

long-term debt

Obligations of the firm that are due in more than one year.

stockholders’ equity

Funds provided by the firm’s preferred and com- mon stock owners.

preferred stock

A hybrid security that has characteristics of both long- term debt and common stock.

DPH TREE FARM, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets Current liabilities

Cash and marketable securities $ 24 $ 25 Accrued wages and taxes $ 20 $ 15

Accounts receivable 70 65 Accounts payable 55 50

Inventory 111 100 Notes payable 45 45

Total $205 $190 Total $ 120 $ 110

Fixed assets Long-term debt 195 190

Gross plant and equipment $368 $300 Total debt 315 300

Less: Depreciation 53 40 Stockholders’ equity

Net plant and equipment $ 315 $260 Preferred stock (5 million shares) $ 5 $ 5

Other long-term Common stock and paid-in surplus (20 million shares) 40 40

assets 50 50 Retained earnings 210 155

Total $365 $ 310 Total $255 $200

Total assets $570 $500 Total liabilities and equity $570 $500

table 2.1 Balance Sheet for DPH Tree Farm, Inc.

figure 2.1

The basic balance sheet Total Assets Total Liabilities and Equity

Current assets Cash and marketable securities Accounts receivable Inventory

Current liabilities Accrued wages and taxes Accounts payable Notes payable

Fixed assets Gross plant and equipment Less: Depreciation Net plant and equipment Other long-term assets

Long-term debt

Stockholders’ equity Preferred stock Common stock and paid-in surplus Retained earnings

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36 part two Financial Statements

Managing the Balance Sheet Managers must monitor a number of issues underlying items reported on their firms’ balance sheets. We examine these issues in detail throughout the text. In this chapter, we briefly introduce them. These issues include:

• The accounting method for fixed asset depreciation.

• The level of net working capital.

• The liquidity position of the firm.

• The method for financing the firm’s assets—equity or debt.

• The difference between the book value reported on the balance sheet and the true market value of the firm.

ACCOUNTING METHOD FOR FIXED ASSET DEPRECIATION Managers can choose the accounting method they use to record depreciation against their fixed assets. Recall from accounting that depreciation is the charge against income that reflects the estimated dollar cost of the firm’s fixed assets. The straight-line method and the MACRS (modified accelerated cost recovery system) are two choices. Companies commonly choose MACRS when computing the firm’s taxes and the straight-line method when reporting income to the firm’s stockholders. The MACRS method accelerates depreciation, which results in higher deprecia- tion expenses and lower taxable income, thus lower taxes, in the early years of a project’s life. Regardless of the depreciation method used, over time both the straight-line and MACRS methods result in the same amount of depreciation and therefore tax (cash) outflows. However, because the MACRS method defers the payment of taxes to later periods, firms often favor it over the straight-line method of depreciation. We discuss this choice further in Chapter 12.

NET WORKING CAPITAL We arrive at a net working capital figure by taking the difference between a firm’s current assets and current liabilities.

Net working capital 5 Current assets 2 Current liabilities (2-2)

So, clearly, net working capital is positive when the firm has more current assets than current liabilities. Table 2.1 shows the 2012 and 2011 year-end bal- ance sheets for DPH Tree Farm, Inc. At year-end 2012, the firm had $205 million of current assets and $120 million of current liabilities. So the firm’s net working capital was $85 million. A firm needs cash and other liquid assets to pay its bills as expenses come due. As described in more detail in Chapter 14, liability hold- ers monitor net working capital as a measure of a firm’s ability to pay its obliga- tions. Positive net working capital values are usually a sign of a healthy firm.

LIQUIDITY As we noted above, any firm needs cash and other liquid assets to pay its bills as debts come due. Liquidity actually refers to two dimensions: the ease with which the firm can convert an asset to cash, and the degree to which such a conversion takes place at a fair market value. You can convert any asset to cash quickly if you price the asset low enough. But clearly, you will wish to convert the asset without giving up a great portion of its value. So a highly liquid asset can be sold quickly at its fair market value. An illiquid asset, on the other hand, cannot be sold quickly unless you reduce the price far below fair value.

Current assets, by definition, remain relatively liquid, including cash and assets that will convert to cash within the next year. Inventory is the least liquid of the current assets. Fixed assets, then, remain relatively illiquid. In the normal course of business, the firm would have no plans to liquefy or convert these tan- gible assets such as buildings and equipment into cash.

common stock and paid-in surplus

The fundamental owner- ship claim in a public or private company.

retained earnings

The cumulative earnings the firm has reinvested rather than pay out as dividends.

net working capital

The difference between a firm’s current assets and current liabilities.

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chapter 2 Reviewing Financial Statements 37

Liquidity presents a double-edged sword on a balance sheet. The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate little or no profits for a firm. For example, cash is the most liquid of all assets, but it earns little, if any, for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, man- agers must consider the trade-off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than gener- ating profits.

DEBT VERSUS EQUITY FINANCING Ever since your high school physics class, you have known that levers are very useful and powerful machines—given a long enough lever, you can move almost anything. Financial leverage is like- wise very powerful. Leverage in the financial sense refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities. The more debt a firm issues as a percentage of its total assets, the greater its financial lever- age. We discuss in later chapters why financial leverage can greatly magnify the firm’s gains and losses for the firm’s stockholders.

When a firm issues debt securities—usually bonds—to finance its activities and assets, debt holders usually demand first claim to a fixed amount of the firm’s cash flows. Their claims are fixed because the firm must only pay the inter- est owed to bondholders and any principal repayments that come due within any given period. Stockholders—who buy equity securities or stocks—claim any cash flows left after debt holders are paid. When a firm does well, financial lever- age increases shareholders’ rewards, since the share of the firm’s profits prom- ised to debt holders is set and predictable.

However, financial leverage also increases risk. Leverage can create the poten- tial for the firm to experience financial distress and even bankruptcy. If the firm has a bad year and cannot make its scheduled debt payments, debt holders can force the firm into bankruptcy. But managers generally prefer to fund firm activi- ties using debt, precisely because they can calculate the cost of doing business without giving away too much of the firm’s value. As described in more detail in Chapter 16, managers often walk a fine line as they decide upon the firm’s capital structure —the amount of debt versus equity financing held on the bal- ance sheet—because it can determine whether the firm stays in business or goes bankrupt.

BOOK VALUE VERSUS MARKET VALUE Beginning finance students usually have already taken accounting, so they are familiar with the accounting point of view. For example, a firm’s balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them. Inflation and market forces make many assets worth more now than they were worth when the firm bought them. So in many cases, book values differ widely from market values for the same assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s current assets—those that mature within a year—the book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short-term assets into cash fairly quickly, so the book value of these assets is generally close to their market value.

The “book value versus market value” issue really arises when we try to determine how much a firm’s fixed assets are worth. In this case, book value is often very different from market value. For example, if a firm owns land

financial leverage

The extent to which debt securities are used by a firm.

capital structure

The amount of debt versus equity financing held on the balance sheet.

LG2

book (or historical cost) value

Assets are listed on the bal- ance sheet at the amount the firm paid for them.

market value

Assets are listed at the amount the firm would get if it sold them.

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38 part two Financial Statements

for 100 years, this asset appears on the balance sheet at its historical cost (of 100 years ago). Most likely, the firm would reap a much higher price on the land upon its sale than the historical price would indicate.

Again, accounting tools reflect the past: Balance sheet assets are listed at his- torical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firm’s assets. Sim- ilarly, the stockholders’ equity listed on the balance sheet generally differs from the true market value of the equity. In this case, the market value may be higher or lower than the value listed on the firm’s accounting books. So financial man- agers and investors often find that balance sheet values are not always the most relevant numbers. The following example illustrates the difference between the book value and the market value of a firm’s assets.

EXAMPLE 2-1

C alculating B ook v ersus M arket V alue EZ Toy, Inc., lists fixed assets of $25 million on its balance sheet. The firm’s fixed assets were recently appraised at $32 million. EZ Toy, Inc.’s, balance sheet also lists current assets at $10 million. Current assets were appraised at $11 million. Current liabilities’ book and market values stand at $6 million and the firm’s long-term debt is $15 million. Calculate the book and market values of the firm’s stockholders’ equity. Construct the book value and market value bal- ance sheets for EZ Toy, Inc.

SOLUTION:

Recall the balance sheet identity in equation 2-1: Assets 5 Liabilities 1 Equity. Rearranging this equation: Equity 5 Assets 2 Liabilities. Thus, the balance sheets would appear as follows:

Similar to problems 2-11, 2-12

For interactive versions of this example visit www.mhhe.com/can2e

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chapter 2 Reviewing Financial Statements 51

! want to know more? Key Words to Search For Updates: Sarbanes-Oxley Act of 2002, financial statements, 10Q filing, 10K filing.

Coldwater Creek Inc. announced today that it received a Nasdaq Staff Determination on June 14, 2006, stating that Coldwater Creek (the “Company”) failed to comply with Mar- ketplace Rule 4310(c)(14) because its Quarterly Report on Form 10-Q for the quarter ended April 29, 2006 (the “Form 10-Q”) filed on June 8, 2006, was incomplete. NASDAQ Staff Determination notices are generated automatically in these circumstances and indicate that, due to such noncompli- ance, Coldwater Creek’s common stock will be subject to delisting.

As indicated in the Form 10-Q, the Company’s indepen- dently registered public accounting firm had not completed its review of the financial information included in the Form 10-Q when it made the filing due to the Company’s pending restatement of certain historical financial information. As a result, the Company was unable to provide the officer certi- fications required by . . . the Sarbanes-Oxley Act of 2002 with the Form 10-Q.

In the interim, the Company is working diligently to com- plete the amendment to its Form 10-K for the fiscal year ended January 28, 2006 to reflect the restated financial informa- tion so that the Company’s independently registered public accounting firm can complete its review of the financial infor- mation in the Form 10-Q. Once this review is completed, the Company intends to file as soon as possible a fully compliant amended Form 10-Q/A, including the certifications required under . . . the Sarbanes-Oxley Act. It is currently expected that the Company’s amended Form 10-K filing will be finalized prior to the Nasdaq hearing date, which will enable the Com- pany to file its amended Form 10-Q and return to compliance with Nasdaq’s Marketplace Rules.

Stories like these are not all that rare. In 2010 and 2011, tech company Quantum and retailer American Apparel also faced similar problems.

Source: The Wall Street Journal, June 20, 2006, p. A3.

COLDWATER CREEK RECEIVES AUTOMATIC DELISTING NOTICE FROM NA SDAQ A S A RESULT OF INCOMPLETE 10-Q FILING

markets finance at work

This process of controlling a firm’s earnings is called earnings management. At the extreme, earnings management has resulted in some widely reported account- ing scandals involving Enron, Merck, WorldCom, and other major U.S. corpora- tions that tried to artificially influence their earnings by manipulating accounting rules. Congress responded to the spate of corporate scandals that emerged after 2001 with the Sarbanes-Oxley Act, passed in June 2002. Sarbanes-Oxley requires public companies to ensure that their corporate boards’ audit committees have considerable experience applying generally accepted accounting principles (GAAP) for financial statements. The act also requires that a firm’s senior man- agement must sign off on the financial statements of the firm, certifying the state- ments as accurate and representative of the firm’s financial condition during the period covered. If a firm’s board of directors or senior managers fail to comply with Sarbanes-Oxley (SOX), the firm may be delisted from stock exchanges.

As illustrated in the Finance at Work reading, Quantum Technologies failed to file quarterly reports for July and October 2009 in a timely manner. As a result, the firm’s common stock became subject to delisting. Congress’s goal in passing SOX was to prevent deceptive accounting and management practices and to bring stability to jittery stock markets battered in 2002 by accounting and managerial scandals that cost employees their life savings and harmed many innocent shareholders as well.

earnings management

The process of controlling a firm’s earnings.

Sarbanes-Oxley Act of 2002

Requires that a firm’s senior management must sign off on the financial statements of the firm, certifying the statements as accurate and represen- tative of the firm’s finan- cial condition during the period covered.

T I M E O U T

2-9 What is earnings management?

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52 part two Financial Statements

table 2.6

DPH TREE FARM, INC. Balance Sheet as of December 31, 2013

(in millions of dollars)

2013 2013

Assets Liabilities and Equity Current assets: Current liabilities:

Cash $ 25 ($24 1 $1) Accrued wages and

Accounts receivable 75 ($70 1 $5) taxes $ 20

Inventory 117 ($111 1 $6) Accounts payable 59 ($55 1 $4)

Total $ 217 Notes payable 45

Total $ 124

Fixed assets:

Gross plant and equipment $395 ($368 1 $27) Long-term debt: $209 ($195 1 0.4($39 2 $4))

Less: Depreciation 53 Stockholders’ equity:

Net plant and equipment $342 Preferred stock (5 million shares) $ 5

Other long-term Common stock and paid-in surplus (20 million shares) 61 ($40 1 0.6($39 2 $4))

assets 50 Retained earnings 210

Total $392 Total $276

Total assets $609 ($570 1 $39) Total liabilities and equity $609 ($570 1 $39)

Personal Application Solution As Chris Ryan examines the 2012 financial statements for DPH Tree Farm, Inc., she needs to remember that the balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time, the income statement reports the total revenues and expenses over a specific period of time, the statement of cash flows shows the firm’s cash flows over a period of time, and the statement of retained earnings reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period.

GAAP procedures dictate how each financial statement is prepared. GAAP requires that the firm recognizes revenue when the firm sells the product, which is not necessarily when the firm receives the cash. Likewise, under GAAP, expenses appear on the income statement as they match sales. That is, the income statement recognizes production and other expenses associated with sales when the firm sells the product. Again, the actual cash outflow associated with producing the goods may actually occur at a very different time than that reported.

(continued)

viewpoints REVISITED Business Application Solution If the managers of DPH Tree Farm increase the firm’s fixed assets by $27 million and net working capital by $8 million in 2013, the balance sheet would look like the one below ( Table 2.6 ). That is, gross fixed assets increase by $27 million, to $395 million; cash, accounts receivable, and inventory would increase by $1 million, $5 million, and $6 million, respectively. DPH Tree Farm’s total assets will thus grow by $39 million to $609 million by year-end 2013. This growth in assets would be financed with $4 million in accounts payable, and the remaining $35 million will be financed with 40 percent long-term debt (0.4 3 $35m 5 $14m) and 60 percent with common stock (0.6 3 $35m 5 $21m).

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reports the amounts of cash generated and cash distributed by a firm during the time period analyzed.

Finally, Chris must remember that firms are required to prepare their financial statements according to GAAP. GAAP allows managers to have significant discretion over their reported earnings, in other words, to manage earnings. Indeed, managers can report their results in a way that indicates to investors that the firm’s assets are growing more steadily than may really be the case. Similarly, the choice of depreciation method— straight-line or MACRS—for fixed assets may make two firms with identical fixed assets appear to have very different results. Thus, Chris may need to delve more deeply into research about this firm’s—or any firm’s—financial condition before she makes any final investment decision.

viewpoints REVISITED Personal Application Solution (concluded) In addition, the income statement contains several noncash items, the largest of which is depreciation. As a result, figures shown on an income statement may not be representative of the actual cash inflows and outflows for a firm during any particular period.

For investors like Chris Ryan, the actual cash flows are often more important than the accounting profit listed on the income statement. Cash, not accounting profit, is needed to pay the firm’s obligations as they come due: to fund the firm’s operations and growth, and to compensate the firm’s owners. So Chris is more likely to find the answers she seeks in the statement of cash flows, which shows the firm’s cash flows over a given period of time. The statement of cash flows

summary of learning goals This chapter reviewed the four basic financial statements. We examined each statement’s major features. The chapter also discussed cautions that readers of financial statements should take when reviewing the documents.

Recall the major financial statements that firms must prepare and provide. In any annual report, you will find the four basic financial statements—the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. These four statements provide an accounting-based picture of a firm’s financial position. These statements often provide a key source of information for firm managers to make financial decisions and for investors to decide whether to invest in the firm.

Differentiate between book (or accounting) value and market value. A firm’s balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets are listed on the balance sheet at the amount the firm paid for them, regardless of what they might be worth today. Market value is the amount the firm would get if it actually sold an

asset. The book value and market value of a firm’s current assets are generally very close in value. However, the book value of a firm’s fixed assets is often very different from the market value.

Explain how taxes influence corporate managers’ and investors’ decisions. Firms pay out a large portion of their earnings as taxes. The U.S. Congress sets (and often changes) the U.S. tax code, which in turn determines corporate tax obligations. The U.S. tax system is extremely complicated and we do not attempt to cover it in detail here. However, taxes are a major expense item for a firm and they are a crucial part of many financial decisions.

Differentiate between accounting income and cash flows. The income statement is prepared using GAAP. Following GAAP, revenue is recognized at the time of sale, which is not necessarily when cash

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chapter equations 2-1 Assets 5 Liabilities 1 Equity

2-2 Net working capital 5 Current assets 2 Current liabilities

2-3 Earnings per share (EPS) 5 Net income available to common stockholders

Total shares of common stock outstanding

2-4 Dividends per share (DPS)

5 Common stock dividends paid

Number of shares of common stock outstanding

2-5 Book value per share (BVPS)

5 Common stock 1 Paid-in surplus 1 Retained earnings

Number of shares of common stock outstanding

2-6 Market value per share (MVPS) 5 Market price of the firm’s common stock

2-7 Average tax rate 5 Tax liability

Taxable income

2-8 FCF 5 [EBIT (1 2 Tax rate) 1 Depreciation] 2 [DGross fixed assets 1 DNet operating working capital]

= Operating cash flow 2 Investment in operating capital

is received. Likewise, under GAAP, expenses appear on the income statement as they match sales. That is, production and other expenses associated with the sales reported on the income statement (for example, cost of goods sold and depreciation) are recognized at the time the product is sold. Again, the actual cash outflow associated with these expenses may occur at a very different point in time.

In addition, the income statement contains several noncash items. The largest is depreciation. As a result, figures shown on an income statement may not represent the actual cash inflows and outflows for a firm during a particular period. For the financial manager and investors, however, these cash flows are precisely the most important information available among the financial documents—more important than the accounting profit listed on the income statement. Cash, not accounting profit, is needed to pay the firm’s obligations as they come due, to fund operations and growth, and to compensate firm owners.

Demonstrate how to use a firm’s financial statements to calculate its cash flows. The statement of cash flows is the financial statement

that shows the firm’s cash flows over a given period of time. The statement of cash flows reports how much cash the firm generates and distributes during the time period analyzed. The bottom line of the statement of cash flows—the difference between cash sources and cash uses—equals the change in cash and marketable securities on the firm’s balance sheet. That is, the statement of cash flows reconciles income statement items and noncash balance sheet items to get to the change in the cash and marketable securities account on the balance sheet over the period of analysis.

Observe cautions that should be taken when examining financial statements. Firms must prepare their financial statements according to GAAP, which provides a common set of standards intended to produce financial statements that are objective and precise. However, GAAP also allows managers significant discretion over the firm’s reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in accounting rules to manage their reported earnings in a wide variety of contexts.

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key terms average tax rate, The percentage of each dollar of taxable income that the firm pays in taxes. (p. 41) balance sheet, The financial statement that reports a firm’s assets, liabilities, and equity at a particular point in time. (p. 34) book (or historical cost) value, Assets are listed on the balance sheet at the amount the firm paid for them. (p. 37) capital structure, The amount of debt versus equity financing held on the balance sheet. (p. 37) cash flows from financing activities, Cash flows that result from debt and equity financing transac- tions. (p. 47) cash flows from investing activities, Cash flows associated with the purchase or sale of fixed or other long-term assets. (p. 46) cash flows from operations, Cash flows that are the direct result of the production and sale of the firm’s products. (p. 46) common stock and paid-in surplus, The funda- mental ownership claim in a public or private company. (p. 35) current assets, Assets that will normally convert to cash within one year. (p. 34) current liabilities, Obligations of the firm that are due within one year. (p. 34) earnings management, The process of controlling a firm’s earnings. (p. 51) EBIT, Earnings before interest and taxes. (p. 39) EBT, Earnings before taxes. (p. 39) financial leverage, The extent to which debt securi- ties are used by a firm. (p. 37) financial statement, Statement that provides an accounting-based picture of a firm’s financial posi- tion. (p. 33) fixed assets, Assets with a useful life exceeding one year. (p. 34) free cash flows, The cash that is actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm’s ongoing operations are made. (p. 48) gross profit, Net sales minus cost of goods sold. (p. 39)

income statement, Financial statement that reports the total revenues and expenses over a specific period of time. (p. 38) liabilities, Funds provided by lenders to the firm. (p. 34) liquidity, The ease of conversion of an asset into cash at a fair value. (p. 34) long-term debt, Obligations of the firm that are due in more than one year. (p. 35) marginal tax rate, The amount of additional taxes a firm must pay out for every additional dollar of tax- able income it earns. (p. 41) marketable securities, Short-term, low-rate invest- ment securities held by the firm for liquidity pur- poses. (p. 34) market value, Assets are listed at the amount the firm would get if it sold them. (p. 37) net change in cash and marketable securities, The sum of the cash flows from operations, investing activities, and financing activities. (p. 47) net income, The bottom line on the income state- ment. (p. 39) net working capital, The difference between a firm’s current assets and current liabilities. (p. 36) preferred stock, A hybrid security that has charac- teristics of both long-term debt and common stock. (p. 35) retained earnings, The cumulative earnings the firm has reinvested rather than pay out as divi- dends. (p. 35) Sarbanes-Oxley Act of 2002, Requires that a firm’s senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm’s financial condition during the period covered. (p. 51) statement of cash flows, Financial statement that shows the firm’s cash flows over a period of time. (p. 44) statement of retained earnings, Financial state- ment that reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period. (p. 49) stockholders’ equity, Funds provided by the firm’s preferred and common stock owners. (p. 35)

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MARION & CARTER, INC. Income Statement for Years Ending December 31, 2012 and 2011

(in millions of dollars)

2012 2011 Net sales $ $ 1,705

Less: Cost of goods sold 830

Gross profits $ 1,123 $ 958

Less: Depreciation 80 75

Other operating expenses 100 90

Earnings before interest and taxes (EBIT) $ 943 $ 793

Less: Interest 112

Earnings before taxes (EBT) $ 844 $ 681

Less: Taxes 248

Net income $ 559 $ 433

Less: Preferred stock dividends $ 62 $ 62

Net income available to common stock holders $ 497 $ 371

Less: Common stock dividends 155

Addition to retained earnings $ 342 $ 216

Per (common) share data:

Earnings per share (EPS) $ $ 1.855

Dividends per share (DPS) $ 0.775 $

Book value per share (BVPS) $ $ 6.035

Market value (price) per share (MVPS) $22.970 $21.470

self-test problems with solutions 1 Financial Statements Listed below are partial financial statements for

Marion & Carter, Inc. Complete each of these statements. Fill in the blanks on the four financial statements.

LG1

MARION & CARTER, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 165 $ 155 Accrued wages and taxes $ 124 $ 95

Accounts receivable 400 Accounts payable 340

Inventory 690 620 Notes payable 342 280

Total $ 1,290 $ 1,175 Total $ 806 $ 685

Fixed assets: Long-term debt: $ 1,210 $

Gross plant and equipment $ $ 1,860 Stockholders’ equity:

Less: Depreciation 330 250 Preferred stock (25 million shares) $25 $ 25

Net plant and equipment $ 1,950 $ 1,610 Common stock and paid-in surplus (200 million shares) 250

Other long-term assets 350 310 Retained earnings 1,299 957

Total $ $ 1,920 Total $ 1,574 $1,232

Total assets $ 3,590 $3,095 Total liabilities and equity $3,590 $

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(continued)

MARION & CARTER, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 165 $ 155 Accrued wages and taxes $ 124 $ 95

Accounts receivable 1,290 2 690 2 165 5 435 400 Accounts payable 340 685 2 280 2 95 5 310

Inventory 690 620 Notes payable 342 280

Total $ 1,290 $1,175 Total $ 806 $ 685

MARION & CARTER, INC. Statement of Cash Flows for Year Ending December 31, 2012

(in millions of dollars)

Section A. Cash flows from operating activities Net income $

Additions (sources of cash):

Depreciation 80

Increase in accrued wages and taxes

Increase in accounts payable 30

Subtractions (uses of cash):

Increase in accounts receivable 235

Increase in inventory

Net cash flow from operating activities: $

Section B. Cash flows from investing activities Subtractions:

Increase in fixed assets 2$420

Increase in other long-term assets

Net cash flow from investing activities: $

Section C. Cash flows from financing activities Additions:

Increase in notes payable $

Increase in long-term debt 32

Increase in common and preferred stock 0

Subtractions:

Pay preferred stock dividends

Pay common stock dividends

Net cash flow from financing activities: $

Section D. Net change in cash and marketable securities $ 10

MARION & CARTER, INC. Statement of Retained Earnings as of December 31, 2012

(in millions of dollars)

Balance of retained earnings, December 31, 2011 $ 957

Plus: Net income for 2012

Less: Cash dividends paid

Preferred stock $

Common stock

Total cash dividends paid

Balance of retained earnings, December 31, 2012 $1,299

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2e 2012 2011 2012 2011

Fixed assets: Long-term debt: $ 1,210 3,095 2 1,232 2 685 5 $1,178

Gross plant and equipment 1,950 1 330 5 $2,280 $1,860 Stockholders’ equity:

Less: Depreciation 330 250 Preferred stock (25 million shares) $ 25 $ 25

Net plant and equipment $ 1,950 $ 1,610 Common stock and paid-in surplus (200 million shares)

250 1,232 2 957 2 25 5 250

Other long-term assets 350 310 Retained earnings 1,299 957

Total 1,950 + 350 5 $2,300 $1,920 Total $ 1,574 $ 1,232

Total assets $3,590 $3,095 Total liabilities and equity $3,590 $3,095

MARION & CARTER, INC. Income Statement for Years Ending December 31, 2012 and 2011

(in millions of dollars)

2012 2011

Net sales 1,123 1 830 5 $ 1,953 $ 1,705

Less: Cost of goods sold 830 1705 2 958 5 747

Gross profits $ 1,123 $ 958

Less: Depreciation 80 75

Other operating expenses 100 90

Earnings before interest and taxes (EBIT) $ 943 $ 793

Less: Interest 943 2 844 5 99 112

Earnings before taxes (EBT) $ 844 $ 681

Less: Taxes 844 2 559 5 285 248

Net income $ 559 $ 433

Less: Preferred stock dividends $ 62 $ 62

Net income available to common stockholders $ 497 $ 371

Less: Common stock dividends 155 371 2 216 5 155

Addition to retained earnings $ 342 $ 216

Per (common) share data:

Earnings per share (EPS) 497/200 5 $ 2.485 $ 1.855

Dividends per share (DPS) $ 0.775 155/200 5 $ 0.775

Book value per share (BVPS) (1,574 2 25)/200 5 $ 7.745 $ 6.035

Market value (price) per share (MVPS) $22.970 $21.470

MARION & CARTER, INC. Statement of Cash Flows for Year Ending December 31, 2012

(in millions of dollars)

Section A. Cash flows from operating activities

Net income $559

Additions (sources of cash):

Depreciation 80

Increase in accrued wages and taxes 124 2 95 5 29

Increase in accounts payable 30

Subtractions (uses of cash):

Increase in accounts receivable 235

Increase in inventory 2 (690 2 620) 5 270

Net cash flow from operating activities: 559 1 80 1 29 1 30 2 35 2 70 5 $593

Section B. Cash flows from investing activities Subtractions:

Increase in fixed assets -$420 Increase in other long-term assets 2(350 2 310) 5 240

Net cash flow from investing activities: 2420 2 40 5 2$460

(continued)

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Section C. Cash flows from financing activities Additions:

Increase in notes payable 342 2 280 5 $62

Increase in long-term debt 32

Increase in common and preferred stock 0

Subtractions:

Pay dividends 62 1 155 5 $217

Net cash flow from financing activities: 62 1 32 2 217 5 2 $123

Section D. Net change in cash and marketable securities $ 10

MARION & CARTER, INC. Statement of Retained Earnings as of December 31, 2012

(in millions of dollars)

Balance of retained earnings, December 31, 2011 $ 957

Plus: Net income for 2012 559

Less: Cash dividends paid

Preferred stock $ 62

Common stock 155

Total cash dividends paid 217

Balance of retained earnings, December 31, 2012 $1,299

2 Corporate Taxes The Talley Corporation had a 2012 taxable income of $365,000 from operations after all operating costs but before: (1) interest expense of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. a. Calculate Talley’s taxable income.

b. Calculate Talley’s income tax liability for 2012.

c. Calculate Talley’s after-tax income for 2012.

d. What are the company’s average and marginal tax rates on taxable income?

Solution: a. Taxable income 5 EBIT 2 Interest expense

1 Taxable portion of dividends received

5 $365,000 2 $50,000 1 $15,000 (1 2 0.7) 5 $319,500

b. Tax liability 5 Tax on base amount 1 Tax rate (amount over base) 5 $22,250 1 0.39 ($319,500 2 $100,000) 5 $107,855

c. After-tax income 5 $365,000 2 $50,000 1 $15,000 2 $107,855 5 $222,145

d. The resulting average tax rate for Talley Corporation is:

Average tax rate 5 Tax liability

Taxable income 5

$107,855 $319,500

5 33.76%

Marginal tax rate 5 39%

3 Free Cash Flow In 2012, McSweeney Power, Inc., earned an EBIT of $675 million, had a tax rate of 33.48 percent, and computed its depreciation expense as $57 million. McSweeney Power’s gross fixed assets increased by $58 million from 2011 to 2012. The firm’s current assets increased by $30 million and spontaneous current liabilities increased by $15 million ($5 million in accrued wages and taxes and $10 million in accounts payable).

LG3

LG5

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2e a. Calculate McSweeney Power’s operating cash flow for 2012.

b. Calculate McSweeney Power’s investment in operating capital for 2012.

c. Calculate McSweeney Power’s free cash flow for 2012.

Solution: a. Operating cash flow for 2012 is:

OCF 5 EBIT (1 2 Tax rate) 1 Depreciation 5 $675m (1 2 0.3348) 1 $57m 5 $506m

b. Investment in operating capital for 2012 is:

IOC 5 DGross fixed assets 1 DNet operating working capital 5 $58m 1 ($30m 2 $15m) 5 $73m

c. Free cash flow for 2012 is:

FCF 5 Operating cash flow 2 Investment in operating capital 5 $506m 2 $73m 5 $433m

In other words, in 2012, McSweeney Power, Inc., had cash flows of $433 million available to pay its stockholders and debt holders.

questions 1. List and describe the four major financial statements. (LG1)

2. On which of the four major financial statements (balance sheet, income state- ment, statement of cash flows, or statement of retained earnings) would you find the following items? (LG1)

a. Earnings before taxes.

b. Net plant and equipment.

c. Increase in fixed assets.

d. Gross profits.

e. Balance of retained earnings, December 31, 20xx.

f. Common stock and paid-in surplus.

g. Net cash flow from investing activities.

h. Accrued wages and taxes.

i. Increase in inventory.

3. What is the difference between current liabilities and long-term debt? (LG1)

4. How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet? (LG1)

5. What are the costs and benefits of holding liquid securities on a firm’s bal- ance sheet? (LG1)

6. Why can the book value and market value of a firm differ? (LG2)

7. From a firm manager’s or investor’s point of view, which is more important—the book value of a firm or the market value of the firm? (LG2)

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8. What do we mean by a progressive tax structure? (LG3)

9. What is the difference between an average tax rate and a marginal tax rate? (LG3)

10. How does the payment of interest on debt affect the amount of taxes the firm must pay? (LG3)

11. The income statement is prepared using GAAP. How does this affect the reported revenue and expense measures listed on the balance sheet? (LG4)

12. Why do financial managers and investors find cash flow to be more impor- tant than accounting profit? (LG4)

13. Which of the following activities result in an increase (decrease) in a firm’s cash? (LG5)

a. Decrease fixed assets.

b. Decrease accounts payable.

c. Pay dividends.

d. Sell common stock.

e. Decrease accounts receivable.

f. Increase notes payable.

14. What is the difference between net cash flow from operating activities, net cash flow from investing activities, and net cash flow from financing activi- ties? (LG5)

15. What are free cash flows for a firm? What does it mean when a firm’s free cash flow is negative? (LG5)

16. What is earnings management? (LG6)

17. What does the Sarbanes-Oxley Act require of firm managers? (LG6)

problems 2-1 Balance Sheet You are evaluating the balance sheet for Goodman’s

Bees Corporation. From the balance sheet you find the following balances: cash and marketable securities 5 $400,000, accounts receivable 5 $1,200,000, inventory 5 $2,100,000, accrued wages and taxes 5 $500,000, accounts payable 5 $800,000, and notes payable 5 $600,000. Calculate Goodman Bees’ net working capital. (LG1)

2-2 Balance Sheet Zoeckler Mowing & Landscaping’s year-end 2012 balance sheet lists current assets of $435,200, fixed assets of $550,800, current liabil- ities of $416,600, and long-term debt of $314,500. Calculate Zoeckler’s total stockholders’ equity. (LG1)

2-3 Income Statement The Fitness Studio, Inc.’s, 2012 income statement lists the following income and expenses: EBIT 5 $538,000, interest expense 5 $63,000, and net income 5 $435,000. Calculate the 2012 taxes reported on the income statement. (LG1)

2-4 Income Statement The Fitness Studio, Inc.’s, 2012 income statement lists the following income and expenses: EBIT = $773,500, interest

basic problems

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2e expense 5 $100,000, and taxes 5 $234,500. The firm has no preferred

stock outstanding and 100,000 shares of common stock outstanding. Cal- culate the 2012 earnings per share. (LG1)

2-5 Corporate Taxes Oakdale Fashions, Inc., had $245,000 in 2012 taxable income. Using the tax schedule in Table 2.3 , calculate the company’s 2012 income taxes. What is the average tax rate? What is the marginal tax rate? (LG3)

2-6 Corporate Taxes Hunt Taxidermy, Inc., is concerned about the taxes paid by the company in 2012. In addition to $42.4 million of taxable income, the firm received $2,975,000 of interest on state-issued bonds and $1,000,000 of dividends on common stock it owns in Oakdale Fashions, Inc. Calculate Hunt Taxidermy’s tax liability, average tax rate, and mar- ginal tax rate. (LG3)

2-7 Statement of Cash Flows Ramakrishnan, Inc., reported 2012 net income of $15 million and depreciation of $2,650,000. The top part of Ramakrishnan, Inc.’s 2012 and 2011 balance sheets is reproduced below (in millions of dollars).

2012 2011 2012 2011

Current assets: Current liabilities:

Cash and marketable securities $ 20 $ 15 Accrued wages and taxes $ 19 $ 18

Accounts receivable 84 75 Accounts payable 51 45

Inventory 121 110 Notes payable 45 40

Total $225 $200 Total $115 $103

Calculate the 2012 net cash flow from operating activities for Ramakrishnan, Inc. (LG4)

2-8 Statement of Cash Flows In 2012, Usher Sports Shop had cash flows from investing activities of - $4,364,000 and cash flows from financing activities of - $5,880,000. The balance in the firm’s cash account was $1,615,000 at the beginning of 2012 and $1,742,000 at the end of the year. Calculate Usher Sports Shop’s cash flow from operations for 2012. (LG4)

2-9 Free Cash Flow You are considering an investment in Fields and Struthers, Inc., and want to evaluate the firm’s free cash flow. From the income statement, you see that Fields and Struthers earned an EBIT of $62 million, had a tax rate of 30 percent, and its depreciation expense was $5 million. Fields and Struthers’ gross fixed assets increased by $32 mil- lion from 2011 to 2012. The firm’s current assets increased by $20 million and spontaneous current liabilities increased by $12 million. Calculate Fields and Struthers’ operating cash flow, investment in operating capital, and free cash flow for 2012. (LG5)

2-10 Free Cash Flow Tater and Pepper Corp. reported free cash flows for 2012 of $39.1 million and investment in operating capital of $22.1 million. Tater and Pepper incurred $13.6 million in depreciation expense and paid $28.9 million in taxes on EBIT in 2012. Calculate Tater and Pepper’s 2012 EBIT. (LG5)

2-11 Statement of Retained Earnings Mr. Husker’s Tuxedos Corp. began the year 2012 with $256 million in retained earnings. The firm earned net income of $33 million in 2012 and paid dividends of $5 million to its pre- ferred stockholders and $10 million to its common stockholders. What is the year-end 2012 balance in retained earnings for Mr. Husker’s Tuxedos? (LG1)

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2-12 Statement of Retained Earnings Use the following information to find dividends paid to common stockholders during 2012. (LG1)

Balance of retained earnings, December 31, 2011 $462m

Plus: Net income for 2012 15m

Less: Cash dividends paid

Preferred stock $ 1m

Common stock

Total cash dividends paid

Balance of retained earnings, December 31, 2012 $470m

intermediate problems

2-13 Balance Sheet Brenda’s Bar and Grill has total assets of $15 million, of which $5 million are current assets. Cash makes up 10 percent of the cur- rent assets and accounts receivable makes up another 40 percent of current assets. Brenda’s gross plant and equipment has a book value of $11.5 million and other long-term assets have a book value of $500,000. Using this information, what is the balance of inventory and the balance of depreciation on Brenda Bar and Grill’s balance sheet? (LG1)

2-14 Balance Sheet Glen’s Tobacco Shop has total assets of $91.8 million. Fifty percent of these assets are financed with debt of which $28.9 million is current liabilities. The firm has no preferred stock but the balance in com- mon stock and paid-in surplus is $20.4 million. Using this information, what is the balance for long-term debt and retained earnings on Glen’s Tobacco Shop’s balance sheet? (LG1)

2-15 Market Value versus Book Value Muffin’s Masonry, Inc.’s, balance sheet lists net fixed assets as $14 million. The fixed assets could currently be sold for $19 million. Muffin’s current balance sheet shows current liabili- ties of $5.5 million and net working capital of $4.5 million. If all the cur- rent accounts were liquidated today, the company would receive $7.25 million cash after paying the $5.5 million in current liabilities. What is the book value of Muffin’s Masonry’s assets today? What is the market value of these assets? (LG2)

2-16 Market Value versus Book Value Ava’s SpinBall Corp. lists fixed assets of $12 million on its balance sheet. The firm’s fixed assets have recently been appraised at $16 million. Ava’s SpinBall Corp.’s bal- ance sheet also lists current assets at $5 million. Current assets were appraised at $6 million. Current liabilities’ book and market values stand at $3 million and the firm’s book and market values of long-term debt are $7 million. Calculate the book and market values of the firm’s stockholders’ equity. Construct the book value and market value bal- ance sheets for Ava’s SpinBall Corp. (LG2)

2-17 Debt versus Equity Financing You are considering a stock investment in one of two firms (NoEquity, Inc., and NoDebt, Inc.), both of which oper- ate in the same industry and have identical operating income of $32.5 million. NoEquity, Inc., finances its $65 million in assets with $64 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $65 million in assets with no debt and $65 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. Calculate the net income and return on assets for the two firms. (LG1)

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2e 2-18 Debt versus Equity Financing You are considering a stock investment

in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $12.5 million. AllDebt, Inc., finances its $25 million in assets with $24 mil- lion in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc., finances its $25 million in assets with no debt and $25 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. Calculate the income available to pay the asset funders (the debt holders and stockholders) and resulting return on assets for the two firms. (LG1)

2-19 Income Statement You have been given the following information for Corky’s Bedding Corp.:

a. Net sales 5 $11,250,000.

b. Cost of goods sold 5 $7,500,000.

c. Other operating expenses 5 $250,000.

d. Addition to retained earnings 5 $1,000,000.

e. Dividends paid to preferred and common stockholders 5 $495,000.

f. Interest expense 5 $850,000.

The firm’s tax rate is 35 percent. Calculate the depreciation expense for Corky’s Bedding Corp. (LG1)

2-20 Income Statement You have been given the following information for Moore’s HoneyBee Corp.:

a. Net sales 5 $32,000,000.

b. Gross profit 5 $18,700,000.

c. Other operating expenses 5 $2,500,000.

d. Addition to retained earnings 5 $4,700,000.

e. Dividends paid to preferred and common stockholders 5 $2,900,000.

f. Depreciation expense 5 $2,800,000.

The firm’s tax rate is 35 percent. Calculate the cost of goods sold and the interest expense for Moore’s HoneyBee Corp. (LG1)

2-21 Corporate Taxes The Dakota Corporation had a 2012 taxable income of $33,365,000 from operations after all operating costs but before (1) interest charges of $8,500,000; (2) dividends received of $750,000; (3) dividends paid of $5,250,000; and (4) income taxes. (LG3)

a. Use the tax schedule in Table 2.3 to calculate Dakota’s income tax liability.

b. What are Dakota’s average and marginal tax rates on taxable income?

2-22 Corporate Taxes Suppose that in addition to $17.85 million of taxable income, Texas Taco, Inc., received $1,105,000 of interest on state-issued bonds and $760,000 of dividends on common stock it owns in Arizona Taco, Inc. (LG3)

a. Use the tax schedule in Table 2.3 to calculate Texas Taco’s income tax liability.

b. What are Texas Taco’s average and marginal tax rates on taxable income?

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CLANCY’S DOG BISCUIT CORPORATION Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 5 $ 5 Accrued wages and taxes $ 10 $ 6

Accounts receivable 20 19 Accounts payable 16 15

Inventory 36 29 Notes payable 14 13

Total $ 61 $ 53 Total $ 40 $ 34

Fixed assets: Long-term debt: $ 57 $ 53

Gross plant and equipment $106 $ 88 Stockholders’ equity:

Less: Depreciation 15 11 Preferred stock (2 million shares) $ 2 $ 2

Net plant and equipment $ 91 $ 77 Common stock and paid-in surplus (5 million shares) 11 11

Other long-term assets 15 15 Retained earnings 57 45

Total $106 $ 92 Total $ 70 $ 58

Total assets $167 $145 Total liabilities and equity $167 $145

CLANCY’S DOG BISCUIT CORPORATION Income Statement for Years Ending December 31, 2012 and 2011

(in millions of dollars)

2012 2011

Net sales $76 $80

Less: Cost of goods sold 38 34

Gross profits $38 $46

Less: Depreciation 4 4

Other operating expenses 6 5

Earnings before interest and taxes (EBIT) $28 $37

Less: Interest 5 5

Earnings before taxes (EBT) $23 $32

Less: Taxes 7 10

Net income $16 $22

Less: Preferred stock dividends $ 1 $ 1

Net income available to common stockholders $15 $ 21

Less: Common stock dividends 3 3

Addition to retained earnings $12 $ 18

Per (common) share data:

Earnings per share (EPS) $ 3.00 $ 4.20

Dividends per share (DPS) $ 0.60 $ 0.60

Book value per share (BVPS) $13.60 $ 11.20

Market value (price) per share (MVPS) $14.25 $ 14.60

2-23 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Clancy’s Dog Biscuit Corporation. (LG5)

2-24 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Valium’s Medical Supply Corporation. (LG5)

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VALIUM’S MEDICAL SUPPLY CORPORATION Income Statement for Years Ending December 31, 2012 and 2011

(in thousands of dollars)

2012 2011 Net sales $888 $798 Less: Cost of goods sold 387 350 Gross profits $501 $ 448 Less: Depreciation 37 35 Other operating expenses 48 42 Earnings before interest and taxes (EBIT) $ 416 $ 371 Less: Interest 46 40 Earnings before taxes (EBT) $370 $ 331 Less: Taxes 129 112 Net income $ 241 $ 219 Less: Preferred stock dividends $ 6 $ 6 Net income available to common stockholders $ 235 $ 213 Less: Common stock dividends 75 75 Addition to retained earnings $ 160 $ 138 Per (common) share data: Earnings per share (EPS) $ 2.35 $ 2.13 Dividends per share (DPS) $ 0.75 $ 0.75 Book value per share (BVPS) $ 7.37 $ 5.77 Market value (price) per share (MVPS) $ 8.40 $ 6.25

2-25 Statement of Cash Flows Chris’s Outdoor Furniture, Inc., has net cash flows from operating activities for the last year of $340 million. The income statement shows that net income is $315 million and deprecia- tion expense is $46 million. During the year, the change in inventory on the balance sheet was $38 million, change in accrued wages and taxes was $15 million, and change in accounts payable was $20 million. At the beginning of the year, the balance of accounts receivable was $50 million. Calculate the end-of-year balance for accounts receivable. (LG5)

2-26 Statement of Cash Flows Dogs 4 U Corporation has net cash flow from financing activities for the last year of $34 million. The company paid $178 million in dividends last year. During the year, the change in notes

VALIUM’S MEDICAL SUPPLY CORPORATION Balance Sheet as of December 31, 2012 and 2011

(in thousands of dollars)

2012 2011 2012 2012

Assets Liabilities and Equity Current assets: Current liabilities: Cash and marketable securities $ 74 $ 73 Accrued wages and taxes $ 58 $ 45 Accounts receivable 199 189 Accounts payable 159 145 Inventory 322 291 Notes payable 131 131 Total $ 595 $ 553 Total $ 348 $ 321

Fixed assets: Long-term debt: $ 565 $ 549 Gross plant and equipment $1,084 $ 886 Stockholders’ equity: Less: Depreciation 153 116 Preferred stock (6 thousand shares) $6 $6 Net plant and equipment $ 931 $ 770 Common stock and paid-in surplus

(100 thousand shares) 120 120

Other long-term assets 130 130 Retained earnings 617 457 Total $ 1,061 $ 900 Total $ 743 $ 583

Total assets $ 1,656 $ 1,453 Total liabilities and equity $1,656 $1,453

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payable on the balance sheet was $39 million and change in common and preferred stock was $0. The end-of-year balance for long-term debt was $315 million Calculate the beginning-of-year balance for long-term debt. (LG5)

2-27 Free Cash Flow The 2012 income statement for Duffy’s Pest Control shows that depreciation expense was $197 million, EBIT was $494 million, and the tax rate was 30 percent. At the beginning of the year, the balance of gross fixed assets was $1,562 million and net operating working capital was $417 million. At the end of the year, gross fixed assets was $1,803 million. Duffy’s free cash flow for the year was $424 million. Calculate the end-of-year balance for net operating working capital. (LG5)

2-28 Free Cash Flow The 2012 income statement for Egyptian Noise Blasters shows that depreciation expense is $85 million, EBIT is $365 million, and taxes paid on EBIT are $119 million. At the end of the year, the balance of gross fixed assets was $655 million. The change in net operating working capital during the year was $73 million. Egyptian’s free cash flow for the year was $190 million. Calculate the beginning-of-year balance for gross fixed assets. (LG5)

2-29 Statement of Retained Earnings Thelma and Louie, Inc., started the year with a balance of retained earnings of $543 million and ended the year with retained earnings of $589 million. The company paid dividends of $35 million to the preferred stockholders and $88 million to common stockholders. Calculate Thelma and Louie’s net income for the year. (LG1)

2-30 Statement of Retained Earnings Jamaica Tours, Inc., started the year with a balance of retained earnings of $1,780 million. The company reported net income for the year of $284 million and paid dividends of $17 million to the preferred stockholders and $59 million to common stockholders. Calculate Jamaica Tour’s end-of-year balance in retained earnings. (LG1)

advanced problems

2-31 Income Statement Listed below is the 2012 income statement for Tom and Sue Travels, Inc.

TOM AND SUE TRAVELS, INC. Income Statement for Year Ending December 31, 2012

(in millions of dollars)

Net sales $16.500

Less: Cost of goods sold 7. 100 Gross profits $ 9.400 Less: Depreciation 2.900 Other operating expenses 3.200 Earnings before interest and taxes (EBIT) $ 3.300 Less: Interest 0.950 Earnings before taxes (EBT) $ 2.350 Less: Taxes 0.705 Net income $ 1.645

The CEO of Tom and Sue’s wants the company to earn a net income of $2.250 million in 2013. Cost of goods sold is expected to be 60 percent of net sales, depreciation and other operating expenses are not expected to change, interest expense is expected to increase to $1.050 million, and the firm’s tax rate will be 30 percent. Calculate the net sales needed to pro- duce net income of $2.250 million. (LG1)

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2e 2-32 Income Statement You have been given the following information for

Kellygirl’s Athletic Wear Corp. for the year 2012:

a. Net sales 5 $38,250,000. b. Cost of goods sold 5 $22,070,000. c. Other operating expenses 5 $5,300,000. d. Addition to retained earnings 5 $1,195,500.

e. Dividends paid to preferred and common stockholders 5 $1,912,000.

f. Interest expense 5 $1,785,000.

g. The firm’s tax rate is 30 percent.

h. In 2013, net sales are expected to increase by $9.75 million.

i. Cost of goods sold is expected to be 60 percent of net sales.

j. Depreciation and other operating expenses are expected to be the same as in 2012.

k. Interest expense is expected to be $2,004,286.

l. The tax rate is expected to be 30 percent of EBT.

m. Dividends paid to preferred and common stockholders will not change.

Calculate the addition to retained earnings expected in 2013. (LG1)

2-33 Free Cash Flow Rebecky’s Flowers 4U, Inc., had free cash flows during 2012 of $43 million, EBIT of $110 million, tax expense paid on its EBIT of $25 million, and depreciation of $14 million. Using this information, fill in the blanks on Rebecky’s balance sheet below. (LG5)

REBECKY’S FLOWERS 4U, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 28 $ 25 Accrued wages and taxes $ 17 $ 15

Accounts receivable 75 65 Accounts payable 50

Inventory 118 100 Notes payable 45 45

Total $ 221 $ 190 Total $ $ 110

Fixed assets: Long-term debt: $ $ 190

Gross plant and equipment $333 $300 Stockholders’ equity:

Less: Depreciation 54 40 Preferred stock (5 million shares) $ 5 $ 5

Net plant and equipment $279 $260 Common stock and paid-in surplus (20 million shares)

40 40

Other long-term assets 50 50 Retained earnings 192 155

Total $329 $310 Total $237 $200

Total assets $550 $500 Total liabilities and equity $550 $500

2-34 Free Cash Flow Vinny’s Overhead Construction had free cash flow during 2012 of $25.4 million. The change in gross fixed assets on Vinny’s balance sheet during 2012 was $7.0 million and the change in net operat- ing working capital was $8.4 million. Using this information, fill in the blanks on Vinny’s income statement below. (LG5)

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research it! Reviewing Financial Statements Go to the website of Walmart Stores, Inc., at www.walmartstores.com and get the latest financial statements from the annual report using the following steps.

Go to Walmart Stores, Inc.’s, website at www.walmartstores.com. Click on Investors, then select Financial Information; next choose Annual Reports; finally, click on the most recent date. This will bring the file onto your computer that contains the relevant data.

Locate the total assets, total equity, net sales, net income, dividends paid, cash flows from operating activities, and cash flows from investing activities for the last two years. How have these items changed over the last two years?

integrated minicase Working with Financial Statements Shown below are partial financial statements for Garners’ Platoon Mental Health Care, Inc. Fill in the blanks on the four financial statements.

GARNERS’ PLATOON MENTAL HEALTH CARE, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities: Cash and marketable securities $ 421 $ Accrued wages and taxes $ 316 $ 242

Accounts receivable 1,020 Accounts payable 867 791

Inventory 1,760 1,581 Notes payable 714

Total $3,290 $ Total $2,055 $ 1,747

Fixed assets: Long-term debt: $3,090 $

Gross plant and equipment $ $4,743 Stockholders’ equity:

Less: Depreciation 840 640 Preferred stock (30 million shares) $ 60 $ 60 Net plant and equipment $4,972 $ Common stock and paid-in surplus

(200 million shares) 637

Other long-term assets 790 Retained earnings 3,312 2,440

Total $5,864 $4,893 Total $4,009 $ 3,137

Total assets $ $7,889 Total liabilities and equity $ 9,154 $7,889

VINNY’S OVERHEAD CONSTRUCTION, CORP. Income Statement for Year Ending December 31, 2012

(in millions of dollars)

Net sales $

Less: Cost of goods sold 116.10 Gross profits $66.00 Less: Depreciation 10.20 Other operating expenses $12.40 Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes (EBT) $ Less: Taxes Net income $27.64

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2e GARNERS’ PLATOON MENTAL HEALTH CARE, INC.

Income Statement for Years Ending December 31, 2012 and 2011 (in millions of dollars)

2012 2011

Net sales $ 4,980 $

Less: Cost of goods sold 2,035

Gross profits $ 2,734 $ 2,313

Less: Depreciation 200 191

Other operating expenses 125 100

Earnings before interest and taxes (EBIT) $ 2,409 $

Less: Interest 285

Earnings before taxes (EBT) $ 2,094 $ 1,737

Less: Taxes

Net income $ 1,327 $ 1,105

Less: Preferred stock dividends $ 60 $

Net income available to common stockholders $ 1,267 $ 1,045

Less: Common stock dividends 395 395

Addition to retained earnings $ 872 $

Per (common) share data:

Earnings per share (EPS) $ $

Dividends per share (DPS) $ $

Book value per share (BVPS) $ $

Market value (price) per share (MVPS) $26.850 $22.500

GARNERS’ PLATOON MENTAL HEALTH CARE, INC. Statement of Cash Flows for Year Ending December 31, 2012

(in millions of dollars)

Section A. Cash flows from operating activities

Net income $

Additions (sources of cash):

Depreciation

Increase in accrued wages and taxes

Increase in accounts payable

Subtractions (uses of cash):

Increase in accounts receivable

Increase in inventory

Net cash flow from operating activities $

Section B. Cash flows from investing activities Subtractions:

Increase in fixed assets $

Increase in other long-term assets

Net cash flow from investing activities $

Section C. Cash flows from financing activities Additions:

Increase in notes payable $

Increase in long-term debt

Increase in common and preferred stock

Subtractions:

Dividends paid

Net cash flow from financing activities $

Section D. Net change in cash and marketable securities $ 26

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GARNERS’ PLATOON MENTAL HEALTH CARE, INC. Statement of Retained Earnings as of December 31, 2012

(in millions of dollars)

Balance of retained earnings, December 31, 2011 $ 2,440

Plus: Net income for 2012 Less: Cash dividends paid Preferred stock Common stock Total cash dividends paid

Balance of retained earnings, December 31, 2012 $

A N S W E R S T O T I M E O U T

2-1 The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time. A firm’s assets must equal (balance) the liabilities and equity used to purchase the assets (hence the term balance sheet ).

2-2 The most liquid assets—called current assets—appear first on the asset side of the balance sheet. The most liquid liabilities—called current liabilities—appear first on the liabilities and equity side of the balance sheet.

2-3 Income statements show the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time—generally one year. Remember that while the balance sheet reports a firm’s position at a point in time, the income statement reports performance over a period of time, for example, over the last year.

2-4 When one corporation owns stock in another corporation, 70 percent of any divi- dends received from other corporations is tax exempt. Only the remaining 30 per- cent is taxed at the receiving corporation’s tax rate.

2-5 The statement of cash flows is a financial statement that shows the firm’s cash flows over a given period of time. This statement reports the amounts of cash that the firm generated and distributed during a particular time period. The bottom line on the statement of cash flows—the difference between cash sources and uses—equals the change in cash and marketable securities on the firm’s balance sheet from the previous year’s balance. That is, the statement of cash flows reconciles income state- ment items and noncash balance sheet items to show changes in the cash and mar- ketable securities account on the balance sheet over the particular analysis period.

2-6 The statement of cash flows separates cash flows into four categories or sections: cash flows from operating activities; cash flows from investing activities; cash flows from financing activities; and net change in cash and marketable securities.

2-7 The statement of retained earnings provides additional details about changes in retained earnings during a reporting period. This financial statement reconciles net income earned during a given period and any cash dividends paid within that period on one side with the change in retained earnings between the beginning and ending of the period on the other.

2-8 If a firm pays out more in dividends than it has net income, retained earnings will decrease.

2-9 Managers have significant discretion over their reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed, within the GAAP framework, firms can “smooth” earnings. That is, firms often take steps to over- or understate earnings at various times. Managers may choose to smooth earnings to show investors that firm assets are growing steadily. Similarly, one firm may be using straight-line depreciation for its fixed assets, while another is using a modified accelerated cost recovery method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS accounting methods, it writes fixed asset values down quickly; assets will thus have lower book values than if the firm used straight-line depreciation methods. This process of controlling a firm’s earnings is called earnings management.

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3 viewpoints

Analyzing Financial Statements

PART TWO

Business Application The managers of DPH Tree Farm, Inc., have released public statements that the firm’s performance surpasses that of other firms in the industry. They cite the firm’s liquidity and asset management positions as particularly strong. DPH’s superior performance in these areas has resulted in superior overall returns for their stockholders. What are the key financial ratios that DPH Tree Farm, Inc., needs to calculate and evaluate in order to justify these statements? (See solution on p. 95)

Personal Application Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm’s annual report but is not sure how to evaluate them or measure the firm’s performance relative to other firms in the industry. What are the financial ratios with which Chris should measure the performance of DPH Tree Farm, Inc.? How can Chris use these ratios to evaluate the firm’s performance? (See solution on p. 95)

So how can these financial ratios work

in your life?

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W e reviewed the major financial statements in Chapter 2. These financial statements provide information on a firm’s financial position at a point in time or its operations over some past period of time. But these financial statements’ real value lies in the fact that manag- ers, investors, and analysts can use the information the statements contain to analyze the current financial performance or condition of the firm. More importantly, managers can use this information to plan changes that will improve the firm’s future performance and, ultimately, its market value. Managers, investors, and analysts universally use ratios to evaluate finan- cial statements. Ratio analysis involves calculating and analyzing financial ratios to assess a firm’s performance and to identify actions that could improve firm performance. The most frequently used ratios fall into five

ratio analysis

The process of calculating and analyzing financial ratios to assess the firm’s performance and to identify actions needed to improve firm performance.

learning goals

LG1 Calculate and interpret major liquidity ratios.

LG2 Calculate and interpret major asset manage- ment ratios.

LG3 Calculate and interpret major debt ratios.

LG4 Calculate and interpret major profitability ratios.

LG5 Calculate and interpret major market value ratios.

LG6 Appreciate how vari- ous ratios relate to one another.

LG7 Understand the differ- ences between time series and cross- sectional ratio analysis.

LG8 Explain cautions that should be taken when examining financial ratios.

llll lll LG

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74 part two Financial Statements

groups: (1) liquidity ratios, (2) asset management ratios, (3) debt management ratios, (4) profitability ratios, and (5) market value ratios. Each of the five groups focuses on a specific area of the financial statements that managers, investors, and analysts assess.

In this chapter, we review these ratios, describe what each ratio means, and identify the general trend (higher or lower) that managers and investment ana- lysts look for in each ratio. Note as we review the ratios that the number calcu- lated for a ratio is not always good or bad and that extreme values (either high or low) can be a bad sign for a firm. We will discuss how a ratio that seems too good can actually be bad for a company. We will also see how ratios interrelate—how a change in one ratio may affect the value of several ratios. It is often hard to make sense of a set of performance ratios. Thus, when managers or investors review a firm’s financial position through ratio analysis, they often start by evaluat- ing trends in the firm’s financial ratios over time and by comparing their firm’s ratios with that of other firms in the same industry. Finally, we discuss cautions that you should take when using ratio analysis to evaluate firm performance. As we go through the chapter, we show sample ratio analysis using the financial statements for DPH Tree Farm, Inc., listed in Tables 2.1 and 2.2.

3.1 ∣ Liquidity Ratios As we stated in Chapter 2, firms need cash and other liquid assets (or current assets) to pay their bills (or current liabilities) as they come due. Liquidity ratios measure the relationship between a firm’s liquid (or current) assets and its cur- rent liabilities. The three most commonly used liquidity ratios are the current ratio, the quick (or acid-test) ratio, and the cash ratio.

Current ratio 5 Current assets

Current liabilities (3-1)

The broadest liquidity measure, the current ratio, measures the dollars of current assets available to pay each dollar of current liabilities.

Quick ratio (acid-test ratio) 5 Current assets 2 Inventory

Current liabilities (3-2)

Inventories are generally the least liquid of a firm’s current assets. Further, inventory is the current asset for which book values are the least reliable mea- sures of market value. In practical terms, what this means is that if the firm must sell inventory to pay upcoming bills, the firm will most likely have to discount inventory items in order to liquidate them, and therefore, they are the current assets on which losses are most likely to occur. Therefore, the quick (or acid-test) ratio measures a firm’s ability to pay off short-term obligations without relying on inventory sales. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities.

Cash ratio 5 Cash and marketable securities

Current liabilities (3-3)

If the firm sells accounts receivable to pay upcoming bills, the firm must often discount the accounts receivable to sell them—the assets once again bring less than their book value. Therefore, the cash ratio measures a firm’s ability to pay short-term obligations with its available cash and marketable securities.

Of course, liquidity on the balance sheet is important. The more liquid assets a firm holds, the less likely the firm is to experience financial distress. Thus, the

LG1

liquidity ratios

Measure the relation between a firm’s liquid (or current) assets and its current liabilities.

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chapter 3 Analyzing Financial Statements 75

EXAMPLE 3-1 LG1

C alculating L iquidity R atios Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm’s 2012 values for the liquidity ratios.

SOLUTION:

The liquidity ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported along- side each ratio.

Current ratio 5 $205m $120m

5 1.71 times Industry average 5 1.50 times

Quick ratio (acid-test ratio) 5 $205m 2 $111m

$120m 5 0.78 times Industry average 5 0.50 times

Cash ratio 5 $24m

$120m 5 0.20 times Industry average 5 0.15 times

All three liquidity ratios show that DPH Tree Farm, Inc., has more liquidity on its balance sheet than the industry average (we discuss the process used to develop an industry average below). Thus, DPH Tree Farm has more cash and other liquid assets (or current assets) available to pay its bills (or current liabilities) as they come due than does the average firm in the tree farm industry.

Similar to Problems 3-13, 3-14

MATH COACH When putting values into the equation, enter them in decimal format, not percentage format CORRECT 1 2 ( 0.1404 3 0.6875) NOT CORRECT 1 2 (14.04 3 68.75)

T I M E O U T

3-18 What does “spreading the financial statements” mean?

3-19 What are retention rates and internal and sustainable growth rates?

3-20 What factors enter into sustainable growth rates?

3.8 ∣ Time Series and Cross-Sectional Analysis We have explored many ratios that allow managers and investors to examine firm performance. But to really analyze performance in a meaningful way, we must interpret our ratio results against some kind of standard or benchmark. To interpret financial ratios, managers, analysts, and investors use two major types of benchmarks: (1) performance of the firm over time ( time series analysis ) and (2) performance of the firm against one or more companies in the same industry ( cross-sectional analysis ).

Analyzing ratio trends over time, along with absolute ratio levels, gives man- agers, analysts, and investors information about whether a firm’s financial con- dition is improving or deteriorating. For example, ratio analysis may reveal that the days’ sales in inventory is increasing. This suggests that inventories, relative to the sales they support, are not being used as well as they were in the past. If this increase is the result of a deliberate policy to increase inventories to offer cus- tomers a wider choice and if it results in higher future sales volumes or increased margins that more than compensate for increased capital tied up in inventory, the increased relative size of the inventories is good for the firm. Managers and investors should be concerned, on the other hand, if increased inventories result from declining sales but steady purchases of supplies and production.

Looking at one firm’s financial ratios, even through time, gives managers, analysts, and investors only a limited picture of firm performance. Ratio analysis almost always includes a comparison of one firm’s ratios relative to the ratios of other firms in the industry, or cross-sectional analysis. Key to cross-sectional anal- ysis is identifying similar firms that compete in the same markets, have similar asset sizes, and operate in a similar manner to the firm being analyzed. Since no two firms are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use in cross-sectional analysis is at best subjective. Note that as we calculated the financial ratios for DPH Tree Farm, Inc., through- out the chapter, we compared them to the industry average. Comparative ratios that can be used in cross-sectional analysis are available from many sources. For

LG7

time series analysis

Analyzing firm performance by monitoring ratio trends.

cross-sectional analysis

Analyzing the performance of a firm against one or more companies in the same industry.

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chapter 3 Analyzing Financial Statements 93

example, Value Line Investment Surveys, Robert Morris Associates, Hoover’s Online (at www.hoovers.com ), and MSN Money website (at moneycentral.msn .com ) are examples of four major sources of financial ratios for numerous indus- tries that operate within the U.S. and worldwide.

T I M E O U T

3-21 What is time series analysis of a firm’s operations?

3-22 What is cross-sectional analysis of a firm’s operations?

3-23 How do time series and cross-sectional analyses differ, and what information would you expect to gain from each?

3.9 ∣ Cautions in Using Ratios to Evaluate Firm Performance Financial statement analysis allows managers, analysts, and investors to bet- ter understand a firm’s performance. However, data from financial statements should not be received without certain cautions. These include:

1. Financial statement data are historical. Historical data may not reflect future performance. While we can make projections using historical data, we must also remember that projections may be inaccurate if historical performance does not persist.

2. As we discussed in Chapter 2, firms use different accounting procedures. For example, inventory methods can vary. One firm may use FIFO (first-in, first-out), transferring inventory at the first purchase price, while another uses LIFO (last-in, first-out), transferring inventory at the last purchase price. Likewise, the depreciation method used to value a firm’s fixed assets over time may vary across firms. One firm may use straight-line depreciation, while another may use an accelerated depreciation method (e.g., MACRS). Particularly, when reviewing cross-sectional ratios, dif- ferences in accounting rules can affect balance sheet values and financial ratios. It is important to know which accounting rules the firms under consideration are using before making any conclusions about their perfor- mance from ratio analysis.

3. Similarly, a firm’s cross-sectional competitors may often be located around the world. Financial statements for firms based outside the United States do not necessarily conform to GAAP. Even beyond inventory pricing and depreciation methods, different accounting standards and procedures make it hard to compare financial statements and ratios of firms based in different countries.

4. Sales and expenses vary throughout the year. Managers, analysts, and investors need to note the timing of these fund flows when perform- ing cross-sectional analysis. Otherwise they may draw conclusions from comparisons that are actually the result of seasonal cash flow differences. Similarly, firms end their fiscal years at different dates. For cross-sectional analysis, this complicates any comparison of balance sheets during the year. Likewise, one-time events, such as a merger, may affect a firm’s

LG8

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94 part two Financial Statements

financial performance. Cross-sectional analysis involving these events can result in misleading conclusions.

5. Large firms often have multiple divisions or business units engaged in different lines of business. In this case, it is difficult to truly compare a set of firms with which managers and investors can perform cross-sectional analysis.

6. Firms often window dress their financial statements to make annual results look better. For example, to improve liquidity ratios calculated with year-end balance sheets, firms often delay payments for raw materials, equipment, loans, and so on to build up their liquid accounts and thus their liquidity ratios. If possible, it is often more accurate to use other than year-end financial statements to conduct ratio analysis.

7. Individual analysts may calculate ratios in modified forms. For example, one analyst may calculate ratios using year-end balance sheet data, while another may use the average of the beginning- and end-of-year balance sheet data. If the firm’s balance sheet has changed significantly during the year, this difference in the way the ratio is calculated can cause large varia- tions in ratio values for a given period of analysis and large variations in any conclusions drawn from these ratios regarding the financial health of the firm.

Financial statement ratio analysis is a major part of evaluating a firm’s per- formance. If managers, analysts, or investors ignore the issues noted here, they may well draw faulty conclusions from their analysis. However, used intelli- gently and with good judgment, ratio analysis can provide useful information on a firm’s current position and hint at future performance.

T I M E O U T

3-24 What cautions should managers and investors take when using ratio analysis to evaluate a firm?

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chapter 3 Analyzing Financial Statements 95

Personal Application Solution To evaluate DPH Tree Farm, Inc.’s, financial statements, Chris Ryan would want to perform ratio analysis in which she uses the financial statements to calculate the most commonly used ratios. These include liquidity ratios, asset management ratios, debt management ratios, profitability ratios, and market value ratios. The value of these ratios for DPH Tree Farms and the tree farming industry are presented in Table 3.1 . Chris might also want to spread the financial statements. These calculations yield common-size, easily compared financial statements that can be used to identify changes in corporate performance as well as how DPH Tree Farm compares to other firms in the industry. Having calculated these ratios, Chris can identify any interrelationships in the ratios by performing a detailed analysis of ROA and ROE using the DuPont system of analysis. A critical part of performance analysis lies in the interpretation of these numbers against some benchmark. To interpret the financial ratios, Chris will also want to evaluate the performance of the firm over time (time series analysis) and the performance of the firm against one or more companies in the same industry (cross- sectional analysis). Finally, Chris needs to exercise some cautions when reviewing data from financial statements. For example, the financial statement data are historical and may not be representative of future performance. Further, she needs to know what accounting rules DPH Tree Farm uses before making any comparisons or conclusions about its performance from ratio analysis. Finally, DPH Tree Farm’s managers may have window dressed their financial statements to make them look better.

viewpoints REVISITED Business Application Solution The managers of DPH Tree Farm, Inc., have stated that its performance surpasses that of other firms in the industry. Particularly strong are the firm’s liquidity and asset management positions. The superior performance in these areas has resulted in superior overall returns for the stockholders of DPH Tree Farm, Inc., according to DPH management. Having analyzed the financial statements using ratio analysis, we could conclude that these statements are partially true. All three liquidity ratios show that DPH Tree Farm holds more liquidity on its balance sheet than the industry average. Thus, DPH Tree Farm has more cash and other liquid assets (or current assets) available to pay its bills (or current liabilities) as they come due than the average firm in the tree farm industry. In all cases, the asset management ratios show that DPH Tree Farm, Inc., is outperforming the industry average in its asset management. The firm is turning over its inventory faster than the average firm in the tree farm industry, thus producing more dollars of sales per dollar of inventory. It is also collecting its accounts receivable faster and paying its accounts payable slower than the average firm. Further, DPH Tree Farm is producing more sales per dollar of fixed assets, working capital, and total assets than the average firm in the industry. The profitability ratios show that DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry. The profit margin, BEP, and ROA are all higher than the industry. Despite this, the ROE for DPH Tree Farm is much lower than the average for the industry.

What the managers do not state is that the debt management ratios show that DPH Tree Farm, Inc., holds less debt on its balance sheet than the average firm in the tree farm industry. This is a good sign in that this lack of financial leverage decreases the firm’s potential for financial distress and even failure. If the firm has a bad year, it has promised relatively few payments to debt holders. Thus, the risk of bankruptcy is small. Further, the firm has more dollars of operating earnings and cash available to meet each dollar of interest obligations on the firm’s debt.

(continued)

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summary of learning goals Ratio analysis involves the process of calculating and analyzing financial ratios to assess a firm’s performance and to identify actions needed to improve firm performance. The most commonly used ratios for ratio analysis fall into five groups: (1) liquidity ratios, (2) asset management ratios, (3) debt management ratios, (4) profitability ratios, and (5) market value ratios. This chapter reviewed these ratios, described what each ratio means, and identified the general trend (higher or lower) managers and investors look for in each ratio.

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the market value ratios show that DPH Tree Farm’s investors will not pay as much for a share of the firm’s stock per dollar of book value and earnings as the average for the industry. The low debt level and high equity level used by DPH Tree Farm relative to the industry is likely a main reason for this unenthusiastic response by DPH investors.

viewpoints REVISITED Business Application Solution (concluded) However, when DPH Tree Farm, Inc., does well, the low level of financial leverage dilutes the return to the stockholders of the firm. This profit dilution will likely upset the firm’s common stockholders. Indeed,

Calculate and interpret major liquidity ratios. Liquidity ratios measure the relation between a firm’s liquid (or current) assets and its current liabilities.

Calculate and interpret major asset management ratios. Asset management ratios measure how efficiently a firm uses its assets (inventory, accounts receivable, and fixed assets), as well as its accounts payable.

Calculate and interpret major debt ratios. Debt management ratios measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets.

Calculate and interpret major profitability ratios. Profitability ratios show the combined effect of liquidity, asset management, and debt management on the overall operating results of the firm.

Calculate and interpret major market value ratios. Market value ratios relate a firm’s stock price to its earnings and book value.

Appreciate how various ratios relate to one another. Many of the ratios we review are interrelated. That is, a change in one ratio may affect the value of several ratios. To see how these interrelations help evaluate firm performance, managers, analysts and investors often perform a detailed analysis of ROA and ROE using the DuPont system of analysis. DuPont system of analysis uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces.

Understand the differences between time series and cross-sectional ratio analysis. When managers, analysts, or investors review a firm’s financial position through ratio analysis, they often start by evaluating trends in the firm’s financial position over time (time series analysis) and by comparing the firm’s performance with that of other firms in the same industry (cross-sectional analysis).

Explain cautions that should be taken when examining financial ratios. The analysis of financial statements allows managers and investors to better understand a firm’s performance. However, some cautions should be remembered when reviewing data from financial statements.

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chapter equations

3-1 Current ratio 5 Current assets

Current liabilities

3-2 Quick ratio (acid-test ratio) 5 Current assets 2 Inventory

Current liabilities

3-3 Cash ratio 5 Cash and marketable securities

Current liabilities

3-4 Inventory turnover 5 Sales or Cost of goods sold

Inventory

3-5 Days’ sales in inventory 5 Inventory 3 365 days

Sales or Cost of goods sold

3-6 Average collection period (ACP) 5 Accounts receivable 3 365 days

Credit sales

3-7 Accounts receivable turnover 5 Credit sales

Accounts receivable

3-8 Average payment period (APP) 5 Accounts payable 3 365 days

Cost of goods sold

3-9 Accounts payable turnover 5 Cost of goods sold

Accounts payable

3-10 Fixed asset turnover 5 Sales

Fixed assets

3-11 Sales to working capital 5 Sales

Working capital

3-12 Total assets turnover 5 Sales

Total assets

3-13 Capital intensity 5 Total assets

Sales

3-14 Debt ratio 5 Total debt

Total assets

3-15 Debt-to-equity 5 Total debt

Total equity

3-16 Equity multiplier 5 Total assets Total equity

or Total assets

Common stockholders’ equity

3-17 Times interest earned 5 EBIT

Interest

3-18 Fixed-charge coverage5 Earnings available to meet fixed charges

Fixed charges

3-19 Cash coverage 5 EBIT 1 Depreciation

Fixed charges

3-20 Profit margin 5 Net income available to common stockholders

Sales

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2e 3-21 Basic earnings power (BEP) 5

EBIT Total assets

3-22 Return on assets (ROA) 5 Net income available to common stockholders

Total assets

3-23 Return on equity (ROE) 5 Net income available to common stockholders

Common stockholders’ equity

3-24 Dividend payout 5 Common stock dividends

Net income available to common stockholders

3-25 Market-to-book ratio 5 Market price per share

Book value per share

3-26 Price-earnings (PE) ratio 5 Market price per share

Earnings per share

3-27 ROA 5 Profit margin 3 Total asset turnover

Net income available to common stockholders

Total assets 5

Net income available to common stockholders

Sales 3

Sales Total assets

3-28

ROE 5 ROA 3 Equity multiplier

Net income available to common stockholders

Common stockholders’ equity 5 ROA 3

Total assets Common stockholders’ equity

3-29 ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier

Net income available to common stockholders

Common stockholders’ equity 5

Net income available to common stockholders

Sales 3

Sales Total assets

3 Total assets

Common stockholders’ equity

3-30 Internal growth rate 5 ROA 3 RR

1 2 (ROA 3 RR)

3-31 Retention ratio (RR) 5 Addition to retained earnings

Net income available to common stockholders

3-32 Retention ratio 5 1 2 Dividend payout ratio

3-33 Sustainable growth rate 5 ROE 3 RR

1 2 (ROE 3 RR)

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key terms asset management ratios, Measure how efficiently a firm uses its assets (inventory, accounts receivable, and fixed assets), as well as its accounts payable. (p. 75) capital structure, The amount of debt versus equity held on the balance sheet. (p. 80) common-size financial statements, Dividing all balance sheet amounts by total assets and all income statement amounts by net sales. (p. 90) cross-sectional analysis, Analyzing the perfor- mance of a firm against one or more companies in the same industry. (p. 92) debt management ratios, Measure the extent to which the firm uses debt (or financial leverage) ver- sus equity to finance its assets. (p. 80) DuPont system of analysis, An analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces. (p. 86) internal growth rate, The growth rate a firm can sustain if it finances growth using only internal financing, that is, retained earnings growth. (p. 90)

liquidity ratios, Measure the relation between a firm’s liquid (or current) assets and its current liabilities. (p. 74) market value ratios, Ratios that relate a firm’s stock price to its earnings and book value. (p. 85) profitability ratios, Ratios that show the combined effect of liquidity, asset management, and debt man- agement on the firm’s overall operating results. (p. 82) ratio analysis, The process of calculating and ana- lyzing financial ratios to assess the firm’s perfor- mance and to identify actions needed to improve firm performance. (p. 73) sustainable growth rate, The growth rate a firm can sustain if it finances growth using both debt and internal financing such that the debt ratio remains constant. (p. 91) time series analysis, Analyzing firm performance by monitoring ratio trends. (p. 92)

self-test problems with solutions 1 Calculating Ratios Listed below are the balance sheet and income

statement for Marion & Carter, Inc. Use these financial statements to calculate liquidity, asset management, debt management, profitability, and market value ratios for 2012.

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MARION & CARTER, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 165 $ 155 Accrued wages and taxes $ 124 $ 95

Accounts receivable 475 400 Accounts payable 360 310

Inventory 650 620 Notes payable 322 280

Total $ 1,290 $ 1,175 Total $ 806 $ 685

Fixed assets: Long term debt: $ 1,210 $ 1,178

Gross plant and equipment $2,280 $ 1,860 Stockholders’ equity:

Less: Depreciation 330 250 Preferred stock (25 million shares) $ 25 $ 25

Net plant and equipment $ 1,950 $ 1,610 Common stock and paid in surplus (200 million shares) 250 250

Other long term assets 350 310 Retained earnings 1,299 957

Total $2,300 $ 1,920 Total $ 1,574 $ 1,232

Total assets $3,590 $3,095 Total liabilities and equity $3,590 $3,095

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Solution:

MARION & CARTER, INC. Income Statement for Years Ending December 31, 2012 and 2011

(in millions of dollars)

2012 2011

Net sales (all credit) $ 2,053 $ 1,705

Less: Cost of goods sold 941 755

Gross profits $ 1,112 $ 950

Less: Depreciation 80 75

Other operating expenses 89 82

Earnings before interest and taxes (EBIT) $ 943 $ 793

Less: Interest 99 112

Earnings before taxes (EBT) $ 844 $ 681

Less: Taxes 285 248

Net income $ 559 $ 433

Less: Preferred stock dividends $ 62 $ 62

Net income available to common stockholders $ 497 $ 371

Less: Common stock dividends 155 155

Addition to retained earnings $ 342 $ 216

Per (common) share data:

Earnings per share (EPS) $ 2.485 $ 1.855

Dividends per share (DPS) $ 0.775 $ 0.775

Book value per share (BVPS) $ 7.745 $ 6.035

Market value (price) per share (MVPS) $22.970 $21.470

Liquidity ratios:

Current ratio 5 $1,290m

$806m 5 1.60 times Quick ratio (acid-test ratio) 5

$1,290m 2 $650m

$806m 5 0.79 times

Cash ratio 5 $165m

$806m 5 0.20 times

Asset management ratios:

Inventory turnover 5 $2,053m

$650m 5 3.16 times Days’ sales in inventory 5

$650m 3 365 days

$2,053m 5 115.56 days

Average collection period 5 $475m 3 365 days

$2,053m 5 84.45 days Accounts receivable turnover 5

$2,053m

$475m 5 4.32 times

Average payment period 5 $360m 3 365 days

$941m 5 139.64 days Accounts payable turnover 5

$941m

$360m 5 2.61 times

Fixed asset turnover 5 $2,053m

$1,950m 5 1.05 times Sales to working capital 5

$2,053m

($1,290m 2 $806m) 5 4.24 times

Total asset turnover 5 $2,053m

$3,590m 5 0.57 times Capital intensity 5

$3,590m

$2,053m 5 1.75 times

Debt management ratios:

Debt ratio 5 $806m 1 $1,210m

$3,590m 5 56.16% Debt-to-equity 5

$806m 1 $1,210m

$1,574m 5 1.28 times

Equity multiplier 5 $3,590m

$1,574m 5 2.28 times Times interest earned 5

$943m

$99m 5 9.53 times

Fixed-charge coverage 5 $943m

$99m 5 9.53 times Cash coverage 5

$943m 1 $80m

$99m 5 10.33 times

Profitability ratios:

Profit margin 5 $497m

$2,053m 5 24.21%

Basic earnings power 5 $943m

$3,590m 5 26.27% Return on assets 5

$497m

$3,590m 5 13.84%

Return on equity 5 $497m

$250m 1 $1,299m 5 32.09% Dividend payout 5

$155m

$497m 5 31.19%

(continued)

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Market value ratios:

Market-to-book ratio 5 $22.970 $7.745

5 2.97 times

Price-earnings ratio 5 $22.970 $2.485

5 9.24 times

2 Internal and Sustainable Growth Rates Calculate the internal growth rate and sustainable growth rate for Marion & Carter, Inc., using the 2012 financial statements.

Solution:

Retention rate (RR) 5 $1,299m 2 $957m

$497m 5 0.6881, or 68.81%

Internal growth rate 5 0.1384 3 0.6881

1 2 (0.1384 3 0.6881) 5 0.1053, or 10.53%

Sustainable growth rate 5 0.3209 3 0.6881

1 2 (0.3209 3 0.6881) 5 0.2834, or 28.34%

LG6

questions

1. Classify each of the following ratios according to a ratio category (liquidity ratio, asset management ratio, debt management ratio, profitability ratio, or market value ratio). (LG1–LG5)

a. Current ratio

b. Inventory turnover

c. Return on assets

d. Average payment period

e. Times interest earned

f. Capital intensity

g. Equity multiplier

h. Basic earnings power

2. For each of the actions listed below, determine what would happen to the current ratio. Assume nothing else on the balance sheet changes and that net working capital is positive. (LG1)

a. Accounts receivable are paid in cash

b. Notes payable are paid off with cash

c. Inventory is sold on account

d. Inventory is purchased on account

e. Accrued wages and taxes increase

f. Long-term debt is paid with cash

g. Cash from a short-term bank loan is received

3. Explain the meaning and significance of the following ratios. (LG1–LG5)

a. Quick ratio

b. Average collection period

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2e c. Return on equity

d. Days’ sales in inventory

e. Debt ratio

f. Profit margin

g. Accounts payable turnover

h. Market-to-book ratio

4. A firm has an average collection period of 10 days. The industry average ACP is 25 days. Is this a good or poor sign about the management of the firm’s accounts receivable? (LG2)

5. A firm has a debt ratio of 20 percent. The industry average debt ratio is 65 percent. Is this a good or poor sign about the management of the firm’s financial leverage? (LG3)

6. A firm has an ROE of 20 percent. The industry average ROE is 12 percent. Is this a good or poor sign about the management of the firm? (LG4)

7. Why is the DuPont system of analysis an important tool when evaluating firm performance? (LG6)

8. A firm has an ROE of 10 percent. The industry average ROE is 15 percent. How can the DuPont system of analysis help the firm’s managers identify the reasons for this difference? (LG6)

9. What is the difference between the internal growth rate and the sustainable growth rate? (LG6)

10. What is the difference between time series analysis and cross-sectional analysis? (LG7)

11. What information does time series and cross-sectional analysis provide for firm managers, analysts, and investors? (LG7)

12. Why is it important to know a firm’s accounting rules before making any conclusions about its performance from ratios analysis? (LG8)

13. What does it mean when a firm window dresses its financial statements? (LG8)

problems

3-1 Liquidity Ratios You are evaluating the balance sheet for Goodman’s Bees Corporation. From the balance sheet you find the following balances: cash and marketable securities 5 $400,000; accounts receivable 5 $1,200,000; inventory 5 $2,100,000; accrued wages and taxes 5 $500,000; accounts payable 5 $800,000; and notes payable 5 $600,000. Calculate Goodman Bees’ current ratio, quick ratio, and cash ratio. (LG1)

3-2 Liquidity Ratios The top part of Ramakrishnan, Inc.’s, 2012 and 2011 balance sheets is listed below (in millions of dollars).

basic problems

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Calculate Ramakrishnan, Inc.’s, current ratio, quick ratio, and cash ratio for 2012 and 2011. (LG1)

3-3 Asset Management Ratios Tater and Pepper Corp. reported sales for 2012 of $23 million. Tater and Pepper listed $5.6 million of inventory on its balance sheet. Using a 365-day year, how many days did Tater and Pepper’s inventory stay on the premises? How many times per year did Tater and Pepper’s inventory turnover? (LG2)

3-4 Asset Management Ratios Mr. Husker’s Tuxedos Corp. ended the year 2012 with an average collection period of 32 days. The firm’s credit sales for 2012 were $56.1 million. What is the year-end 2012 balance in accounts receivable for Mr. Husker’s Tuxedos? (LG2)

3-5 Debt Management Ratios Tiggie’s Dog Toys, Inc., reported a debt-to- equity ratio of 1.75 times at the end of 2012. If the firm’s total debt at year-end was $25 million, how much equity does Tiggie’s have on its balance sheet? (LG3)

3-6 Debt Management Ratios You are considering a stock investment in one of two firms (LotsofDebt, Inc., and LotsofEquity, Inc.), both of which operate in the same industry. LotsofDebt, Inc., finances its $30 million in assets with $29 million in debt and $1 million in equity. LotsofEquity, Inc., finances its $30 million in assets with $1 million in debt and $29 million in equity. Calculate the debt ratio, equity multiplier, and debt-to-equity ratio for the two firms. (LG3)

3-7 Profitability Ratios Maggie’s Skunk Removal Corp.’s 2012 income state- ment listed net sales of $12.5 million, EBIT of $5.6 million, net income available to common stockholders of $3.2 million, and common stock dividends of $1.2 million. The 2012 year-end balance sheet listed total assets of $52.5 million and common stockholders’ equity of $21 million with 2 million shares outstanding. Calculate the profit margin, basic earnings power, ROA, ROE, and dividend payout. (LG4)

3-8 Profitability Ratios In 2012, Jake’s Jamming Music, Inc., announced an ROA of 8.56 percent, ROE of 14.5 percent, and profit margin of 20.5 per- cent. The firm had total assets of $9.5 million at year-end 2012. Calculate the 2012 values of net income available to common stockholders, com- mon stockholders’ equity, and net sales for Jake’s Jamming Music, Inc. (LG4)

3-9 Market Value Ratios You are considering an investment in Roxie’s Bed & Breakfast Corp. During the last year, the firm’s income statement listed an addition to retained earnings of $4.8 million and common stock dividends of $2.2 million. Roxie’s year-end balance sheet shows common stockholders’ equity of $35 million with 10 million shares of common stock outstanding. The common stock’s market price per share was $9.00. What is Roxie’s Bed & Breakfast’s book value per share and earnings per share? Calculate the market-to-book ratio and PE ratio. (LG5)

2012 2011 2012 2011

Current assets: Current liabilities:

Cash and marketable securities $ 34 $ 25 Accrued wages and taxes $ 32 $ 31

Accounts receivable 143 128 Accounts payable 87 76

Inventory 206 187 Notes payable 76 68

Total $383 $340 Total $195 $175

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3-15 Liquidity Ratios Brenda’s Bar and Grill has current liabilities of $15 million. Cash makes up 10 percent of the current assets and accounts receivable makes up another 40 percent of current assets. Brenda’s cur- rent ratio is 2.1 times. Calculate the value of inventory listed on the firm’s balance sheet. (LG1)

3-16 Liquidity and Asset Management Ratios Mandesa, Inc., has current liabil- ities of $8 million, current ratio of 2 times, inventory turnover of 12 times, average collection period of 30 days, and credit sales of $64 million. Calcu- late the value of cash and marketable securities. (LG1, LG2)

3-17 Asset Management and Profitability Ratios You have the following information on Els’ Putters, Inc.: sales to working capital is 4.6 times, profit margin is 20 percent, net income available to common stockholders is $5 million, and current liabilities are $6 million. What is the firm’s bal- ance of current assets? (LG2, LG4)

3-1 8 Asset Management and Debt Management Ratios Use the following information to complete the balance sheet below. Sales are $8.8 million, capital intensity ratio is 2.10 times, debt ratio is 55 percent, and fixed asset turnover is 1.2 times. (LG2, LG3)

3-10 Market Value Ratios Dudley Hill Golf Club’s market-to-book ratio is currently 2.5 times and the PE ratio is 6.75 times. If Dudley Hill Golf Club’s common stock is currently selling at $22.50 per share, what is the book value per share and earnings per share? (LG5)

3-11 DuPont Analysis If Silas 4-Wheeler, Inc., has an ROE of 18 percent, equity multiplier of 2, and a profit margin of 18.75 percent, what is the total asset turnover and the capital intensity? (LG6)

3-12 DuPont Analysis Last year, Hassan’s Madhatter, Inc., had an ROA of 7.5 percent, a profit margin of 12 percent, and sales of $25 million. Calcu- late Hassan’s Madhatter’s total assets. (LG6)

3-13 Internal Growth Rate Last year, Lakesha’s Lounge Furniture Corpora- tion had an ROA of 7.5 percent and a dividend payout ratio of 25 percent. What is the internal growth rate? (LG6)

3-14 Sustainable Growth Rate Last year Lakesha’s Lounge Furniture Corporation had an ROE of 17.5 percent and a dividend payout ratio of 20 percent. What is the sustainable growth rate? (LG6)

intermediate problems

Assets Liabilities and Equity

Current assets $ Total liabilities $

Fixed assets Total equity

Total assets $ Total liabilities and equity $

3-19 Debt Management Ratios Tiggie’s Dog Toys, Inc., reported a debt-to- equity ratio of 1.75 times at the end of 2012. If the firm’s total assets at year-end were $25 million, how much of their assets are financed with debt and how much with equity? (LG3)

3-20 Debt Management Ratios Calculate the times interest earned ratio for LaTonya’s Flop Shops, Inc., using the following information. Sales are $1.5 million, cost of goods sold is $600,000, depreciation expense is $150,000, other operating expenses is $300,000, addition to retained

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earnings is $146,250, dividends per share is $1, tax rate is 30 percent, and number of shares of common stock outstanding is 90,000. LaTonya’s Flop Shops has no preferred stock outstanding. (LG3)

3-21 Profitability and Asset Management Ratios You are thinking of invest- ing in Nikki T’s, Inc. You have only the following information on the firm at year-end 2012: net income is $250,000, total debt is $2.5 million, and debt ratio is 55 percent. What is Nikki T’s ROE for 2012? (LG2, LG4)

3-22 Profitability Ratios Rick’s Travel Service has asked you to help piece together financial information on the firm for the most current year. Man- agers give you the following information: sales are $8.2 million, total debt is $2.1 million, debt ratio is 40 percent, and ROE is 18 percent. Using this information, calculate Rick’s ROA. (LG4)

3-23 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $35. The firm has total assets of $50 million, debt ratio of 65 percent, no preferred stock, and 3 million shares of common stock outstanding. Cal- culate the market-to-book ratio for Leonatti Labs. (LG5)

3-24 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $15. The firm has a profit margin of 8 percent, total assets of $42 million, a total asset turnover of 0.75, no preferred stock, and 3 million shares of common stock outstanding. Calculate the PE ratio for Leonatti Labs. (LG5)

3-25 DuPont Analysis Last year, Stumble-on-Inn, Inc., reported an ROE of 18 percent. The firm’s debt ratio was 55 percent, sales were $15 million, and the capital intensity was 1.25 times. Calculate the net income for Stumble- on-Inn last year. (LG6)

3-26 DuPont Analysis You are considering investing in Nuran Security Ser- vices. You have been able to locate the following information on the firm: total assets are $24 million, accounts receivable are $3.3 million, ACP is 25 days, net income is $3.5 million, and debt-to-equity is 1.2 times. Calculate the ROE for the firm. (LG6)

3-27 Internal Growth Rate Dogs R Us reported a profit margin of 10.5 percent, total asset turnover of 0.75 times, debt-to-equity of 0.80 times, net income of $500,000, and dividends paid to common stockholders of $200,000. The firm has no preferred stock outstanding. What is Dogs R Us’s internal growth rate? (LG6)

3-28 Sustainable Growth Rate You have located the following information on Webb’s Heating & Air Conditioning: debt ratio is 54 percent, capital inten- sity is 1.10 times, profit margin is 12.5 percent, and the dividend payout is 25 percent. Calculate the sustainable growth rate for Webb. (LG6)

Use the following financial statements for Lake of Egypt Marina, Inc., to answer Problems 3-29 through 3-33.

LAKE OF EGYPT MARINA, INC. Balance Sheet as of December 31, 2012 and 2011

(in millions of dollars)

2012 2011 2012 2011

Assets Liabilities and Equity Current assets: Current liabilities:

Cash and marketable securities $ 75 $ 65 Accrued wages and taxes $ 40 $ 43

Accounts receivable 115 110 Accounts payable 90 80

Inventory 200 190 Notes payable 80 70

Total $390 $365 Total $210 $ 193

(continued)

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3-29 Spreading the Financial Statements Spread the balance sheets and income statements of Lake of Egypt Marina, Inc., for 2012 and 2011. (LG6)

3-3 0 Calculating Ratios Calculate the following ratios for Lake of Egypt Marina, Inc., as of year-end 2012. (LG1–LG5)

Fixed assets: Long term debt: $300 $280

Gross plant and equipment $580 $471 Stockholders’ equity:

Less: Depreciation 110 100 Preferred stock (5 million shares) $ 5 $ 5

Net plant and equipment $470 $371 Common stock and paid in surplus (65 million shares) 65 65

Other long term assets 50 49 Retained earnings 330 242

Total $520 $420 Total $400 $312

Total assets $ 910 $785 Total liabilities and equity $ 910 $785

LAKE OF EGYPT MARINA, INC. Income Statement for Years Ending December 31, 2012 and 2011

(in millions of dollars)

2012 2011 Net sales (all credit) $ 515 $ 432 Less: Cost of goods sold 230 175 Gross profits $ 285 $ 257 Less: Depreciation 22 20 Other operating expenses 30 25 Earnings before interest and taxes (EBIT) $ 233 $ 212 Less: Interest 33 30 Earnings before taxes (EBT) $ 200 $ 182 Less: Taxes 57 55 Net income $ 143 $ 127 Less: Preferred stock dividends $ 5 $ 5 Net income available to common stockholders $ 138 $ 122 Less: Common stock dividends 65 65 Addition to retained earnings $ 73 $ 57 Per (common) share data: Earnings per share (EPS) $ 2.123 $ 1.877

Dividends per share (DPS) $ 1.000 $ 1.000 Book value per share (BVPS) $ 6.077 $ 4.723 Market value (price) per share (MVPS) $14.750 $12.550

Lake of Egypt Marina, Inc. Industry

a. Current ratio 2.00 times

b. Quick ratio 1.20 times c. Cash ratio 0.25 times d. Inventory turnover 3.60 times e. Days’ sales in inventory 101.39 days f. Average collection period 32.50 days g. Average payment period 45.00 days h. Fixed asset turnover 1.25 times i. Sales to working capital 4.25 times j. Total asset turnover 0.85 times k. Capital intensity 1.18 times l. Debt ratio 62.50% m. Debt-to-equity 1.67 times n. Equity multiplier 2.67 times

(continued)

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o. Times interest earned 8.50 times

p. Cash coverage 8.75 times

q. Profit margin 28.75%

r. Basic earnings power 32.50%

s. ROA 19.75%

t. ROE 36.88%

u. Dividend payout 35.00%

v. Market-to-book ratio 2.55 times

w. PE ratio 15.60 times

3-31 DuPont Analysis Construct the DuPont ROA and ROE breakdowns for Lake of Egypt Marina, Inc. (LG6)

3-32 Internal and Sustainable Growth Rates Calculate the internal and sus- tainable growth rate for Lake of Egypt Marina, Inc. (LG6)

3-33 Cross-Sectional Analysis Using the ratios from Problem 3-30 for Lake of Egypt Marina, Inc., and the industry, what can you conclude about Lake of Egypt Marina’s financial performance for 2012? (LG7)

advanced problems

3-34 Ratio Analysis Use the following information to complete the balance sheet below. (LG1–LG5) Current ratio 5 2.5 times Profit margin 5 10% Sales 5 $1,200m ROE 5 20% Long-term debt to Long-term debt and equity 5 55%

3-35 Ratio Analysis Use the following information to complete the balance sheet below. (LG1–LG5) Current ratio 5 2.20 times Credit sales 5 $1,200m Average collection period 5 60 days Inventory turnover 5 1.50 times Total asset turnover 5 0.75 times Debt ratio 5 60%

Current assets $ Current liabilities $210m

Fixed assets Long-term debt

Stockholders’ equity

Total assets $ Total liabilities and equity $

Cash $

Accounts receivable Current liabilities $500m

Inventory Long-term debt

Current assets $ Total debt $

Fixed assets Stockholders’ equity

Total assets $ Total liabilities and equity $

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research it! Analyzing Financial Statements Go to the website of Walmart Stores, Inc., at www.walmartstores.com and get the latest financial statements from the annual report using the following steps.

Click on “Investors.” Click on “Financial Information.” Click on “Annual Reports.” Click on the most recent date. This will bring the file onto your computer that contains the relevant data.

Using the most recent balance sheet and income statement, calculate the financial ratios for the firm, including the internal and sustainable growth rates.

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GARNERS’ PLATOON MENTAL HEALTH CARE, INC. Balance Sheet as of December 31, 2012

(in millions of dollars)

Assets Liabilities and Equity

Current assets: Current liabilities:

Cash and marketable securities $ 421 Accrued wages and taxes $316

Accounts receivable 1,109 Accounts payable 867

Inventory 1,760 Notes payable 872

Total $3,290 Total $2,055

Fixed assets: Long term debt: $3,090

Gross plant and equipment $ 5,812 Stockholders’ equity:

Less: Depreciation 840 Preferred stock (30 million shares) $ 60

Net plant and equipment $4,972 Common stock and paid in surplus (200 million shares) 637

Other long term assets 892 Retained earnings 3,312

Total $5,864 Total $4,009

Total assets $9,154 Total liabilities and equity $ 9,154

integrated mini-case Working with Financial Statements Listed below are the 2012 financial statements for Garners’ Platoon Mental Health Care, Inc. Spread the balance sheet and income statement. Calculate the financial ratios for the firm, including the internal and sustainable growth rates. Using the DuPont system of analysis and the industry ratios reported below, evaluate the performance of the firm.

GARNERS’ PLATOON MENTAL HEALTH CARE, INC. Income Statement for Year Ending December 31, 2012

(in millions of dollars)

Net sales (all credit) $ 4,980

Less: Cost of goods sold 2,246

Gross profits $ 2,734

Less: Depreciation 200

Other operating expenses 125

Earnings before interest and taxes (EBIT) $ 2,409

Less: Interest 315

Earnings before taxes (EBT) $ 2,094

Less: Taxes 767

Net income $ 1,327

(continued )

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Less: Preferred stock dividends $ 60

Net income available to common stockholders $ 1,267

Less: Common stock dividends 395

Addition to retained earnings $ 872

Per (common) share data:

Earnings per share (EPS) $ 6.335

Dividends per share (DPS) $ 1.975

Book value per share (BVPS) $ 19.745

Market value (price) per share (MVPS) $26.850

Garners’ Platoon Mental Health Care, Inc. Industry

Current ratio 2.00 times

Quick ratio 1.20 times

Cash ratio 0.25 times

Inventory turnover 2.50 times

Days’ sales in inventory 146.00 days

Average collection period 91.00 days

Average payment period 100.00 days

Fixed asset turnover 1.25 times

Sales to working capital 4.00 times

Total asset turnover 0.50 times

Capital intensity 2.00 times

Debt ratio 50.00%

Debt-to-equity 1.00 times

Equity multiplier 2.00 times

Times interest earned 7.25 times

Cash coverage 8.00 times

Profit margin 18.75%

Basic earnings power 19.90%

ROA 9.38%

ROE 18.75%

Dividend payout 35.00%

Market-to-book ratio 1.30 times

PE ratio 4.10 times

A N S W E R S T O T I M E O U T

3-1 The three most commonly used liquidity ratios are the current ratio, the quick (or acid-test) ratio, and the cash ratio.

3-2 The current ratio measures the dollars of current assets available to pay each dollar of current liabilities. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities. The cash ratio measures the dollars of cash and marketable securities available to pay each dollar of current liabilities

3-3 The more liquid assets a firm holds, the less likely it is that the firm will experience financial distress. Thus, the higher the liquidity ratios, the less liquidity risk a firm has. But liquid assets generate little, if any, profits for the firm. In contrast, fixed assets are illiquid, but generate revenue for the firm. Thus, extremely high levels of liquidity guard against liquidity crises but at the cost of lower returns on assets.

3-4 The major asset management ratios are the inventory turnover, the days’ sales in inventory, the average collection period (ACP), the accounts receivable turnover, the average payment period (APP), the accounts payable turnover, the fixed asset turnover, the sales to working capital, the total asset turnover, and the capital intensity.

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2e 3-5 In general, a firm wants to produce a high level of sales per dollar of inventory.

That is, it wants to turn inventory over as quickly as possible. However, if the inventory turnover ratio is extremely high and the days’ sales in inventory is extremely low, the firm may not be holding sufficient inventory to prevent running out of the raw materials needed to keep the production process going.

In general, a firm wants to collect its accounts receivable as quickly as possible. However, if the accounts receivable turnover ratio is extremely high and the ACP is extremely low, the firm’s accounts receivable policy may be so strict that custom- ers prefer to do business with competing firms.

In general, a firm wants to pay for its purchases as slowly as possible. Thus, a high APP or a low accounts payable turnover is generally a sign of good manage- ment. However, if the APP is extremely high and the accounts payable turnover is extremely low, the firm may be abusing the credit terms that its raw materials sup- pliers offer. At some point, the firm’s suppliers may revoke its ability to buy raw materials on account and the firm will lose this source of free financing.

In general, high fixed asset turnover and sales to working capital are signs of good management. However, if either the fixed asset turnover or sales to working capital is extremely high, the firm may be close to its maximum production capacity.

In general, the higher the total asset turnover and lower the capital intensity, the more efficient the overall asset management of the firm will be. However, as described above, inventory stockouts, capacity problems, or tight account receiv- ables policies can all lead to a high fixed asset turnover and may actually be signs of poor firm management.

3-6 Many of the ratios are mirror images of one another because one ratio might be the inverse of another ratio. For example, the inventory turnover ratio measures the number of times per year that inventory is turned over, while the days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold.

3-7 The major debt management ratios are the debt ratio, the debt-to-equity, the equity multiplier, the times interest earned, the fixed-charge coverage, and the cash coverage.

3-8 Low levels of debt will lead to a dilution of the return to stockholders due to a greater increased use of equity as well as not taking advantage of the tax deduct- ibility of interest expense. However, high levels of debt increase a firm’s potential for financial distress and even failure. If the firm has a bad year and cannot make its promised debt payments, debt holders can force the firm into bankruptcy.

3-9 In deciding the level of debt versus equity financing to hold on the balance sheet, managers must consider the trade-off between maximizing cash flows to the firm’s stockholders versus the risk of being unable to make promised debt payments. When firms do well, financial leverage creates more cash flows to share with stockholders— it magnifies the return to the stockholders of the firm. This magnification is one rea- son that firm stockholders encourage the use of debt financing. However, financial leverage also increases the firm’s potential for financial distress and even failure. If the firm has a bad year and cannot make promised debt payments, debt holders can force the firm into bankruptcy. Thus, a firm’s current and potential debt holders (and even stockholders) look at equity financing as a safety cushion that can absorb fluctu- ations in the firm’s earnings and asset values and guarantee debt service payments.

3-10 The major profitability ratios are the profit margin, the basic earnings power, the return on assets (ROA), the return on equity (ROE), and the dividend payout.

3-11 For all but the dividend payout, the higher the value of the ratio, the higher the profitability of the firm. But just as has been the case previously in this chapter, high profitability ratio levels may result from poor management in other areas of the firm as much as superior financial management.

3-12 Generally, a high ROE is considered to be a positive sign of firm performance. However, if performance comes from a high degree of financial leverage, a high ROE can indicate a firm with an unacceptably high level of bankruptcy risk as well.

3-13 The major market value ratios are the market-to-book ratio and the price-earnings (or PE) ratio.

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3-14 Generally, the higher the market-to-book and PE ratios, the better the firm’s per- formance. However, for value seeking investors, high market-to-book and PE firms indicate expensive companies. Further, higher PE ratios carry greater risk because investors are willing to pay higher prices today for a stock in anticipation of higher earnings in the future. These earnings may or may not materialize. Low-PE firms are generally companies with little expected growth or low earnings.

3-15 The price-earnings (or PE) ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock. PE ratios are often quoted in multiples—the number of dollars per share—which fund managers, investors, and analysts compare within industry classes. Managers and investors often use PE ratios to evaluate the relative financial performance of the firm’s stock.

3-16 The basic DuPont equation looks at ROA as the product of the profit margin and the total asset turnover ratios. The DuPont ROE equation looks at ROE as a prod- uct of the profit margin, the total asset turnover, and the equity multiplier.

3-17 This presentation of ROA and ROE allows managers, analysts, and investors to look at the return on assets and return on equity as a function of the net profit margin (profit per dollar of sales from the income statement), total asset turnover (efficiency in the use of assets from the balance sheet), and the equity multiplier (financial leverage from the balance sheet).

3-18 Managers, analysts, and investors can compute additional ratios by dividing all balance sheet amounts by total assets and all income statement amounts by net sales. These calculations, sometimes called “spreading the financial statements,” yield what we call “common-size” financial statements that adjust for sizes.

3-19 The internal growth rate is the growth rate a firm can sustain if it uses only internal financing—that is, retained earnings—to finance future growth. The retention ratio represents the portion of net income that the firm reinvests as retained earnings. Since a firm either pays its net income as dividends to its stockholders or reinvests those funds as retained earnings, the dividend payout and the retention ratios must always add to one. The sustainable growth rate is the maximum growth rate that can be achieved when managers finance asset growth with new debt and retained earnings.

3-20 A firm’s sustainable growth depends on four factors: (1) the profit margin (operat- ing efficiency), (2) the total asset turnover (efficiency in asset use), (3) financial leverage (the use of debt versus equity to finance assets), and (4) profit retention (reinvestment of net income into the firm rather than paying it out as dividends).

3-21 Time series analysis involves analyzing ratio trends over time, along with absolute ratio levels. It gives managers, analysts, and investors information about whether a firm’s financial condition is improving or deteriorating.

3-22 Cross-sectional analysis involves a comparison of one firm’s ratios relative to the ratios of other firms in the industry. Key to cross-sectional analysis is identifying similar firms in that they compete in the same markets, have similar asset sizes, and operate in a similar manner to the firm being analyzed.

3-23 Analyzing ratio trends over time, along with absolute ratio levels, gives managers, analysts, and investors information about whether a firm’s financial condition is improving or deteriorating. Cross-sectional analysis gives the manager a compari- son of one firm’s ratios relative to the ratios of other firms in the industry.

3-24 Data from financial statements should not be received without certain cautions. These include: (1) Financial statement data are historical; historical data may not reflect future performance. (2) Firms use different accounting procedures. (3) A firm’s cross-sectional competitors may often be located around the world; financial statements for firms based outside the U.S. do not necessarily conform to GAAP. (4) Sales and expenses vary throughout the year. Managers, analysts, and investors need to note the timing of these fund flows when performing cross- sectional analysis. Similarly, firms end their fiscal years at different dates. Like- wise, one-time events, such as a merger, may affect a firm’s financial performance. (5) Large firms often have multiple divisions or business units engaged in different lines of business. (6) Firms often window dress their financial statements to make annual results look better.

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