56

Part

Financin!Analysis and Planning

In the second pafi of the chapter we will explore the impact of inflation and.disinflation on financial operations over the last decade. The student begins to appreciate
the impact of rising prices (or at times, declining prices) on the various financial ratios.

Classification SYstem

I\': ;rli sipara:e

---

!--

The chapter concludes with a discussion of how other factors-in addition to price changes-may distort the financial statements of the firm. Terms such as net income ta sales, relurn on .investment. and inventory turnover take on much greater meaning when they are evaluated through the eyes of a financial manager who does more than merely pick out the top or bottom line of an income statement. The examples in the chapter are designed from the viewpoint of a financial manager (with only minor attention to accounting theory).

A.

Profitabihr-v ran'
1 I. -. --D-iI rL'rr' l('tu-ltail!-! tr:-l GE--i--'

B-

Assetmilizam
'
a ---

P;g31r =':
\-1r r--,-> r_+:e

-! -

*a**

&xxm$gw&*

Ratios are used in much of our daily life. We btry cars based on miles per gallon; we evaluate baseball players by earned run and batting alerages, basketball players by fleld goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the signiflcance of the resultanl number. FiUancial ratios are used to weigh and evaluate the operating performance of the firr_n. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may apper satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio

5- hrer:.-l-: -. F:le: -": ! T'lr-:' a-:=: G Lqndilyrerct 9. Ci:::E:::= ;,fr- Q-i-:r. := D- DeHlmir7ff
,

-. l=:s li:' 1-: . F' r:c ;:';

T-:e l-:

i )er::;

-':

m w

Dsn & Eradstreet

For example, are. earnlngs of $50,000 actually good? If we earned $50,000 on $500,000 of sales 110 pdrbent "profit margin" ratio), that might be quite satisfactorywhereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this "number-crunching" process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, and numerous other factors. For comparative purposes, a number of organizations provide industry data. For example, Dun & Bradstreet compiles data on 800 different lines of business, while Robert Morris Associates provides ratios on over 150 industry classifications. Often the most vaiuable industry figures come from the various trade organizations to which firms belong (for example, the National Retail Furniture Association or the National Hardware Association). 'Many libraries and universities subscribe to financial services such as Standard & Poor's Industry Surveys and Corporate Reports, the Value Line Investment Survey, ald \Ioody's Corporation. Standard & Poor's also leases a computer database called Compustat to banks, colporations, investment organizations, and universities. Compustat roc:ains hnancial statement data on over 16,000 companies for a2}-year period. R3IiLas .ejl also be found on such Internet Web sites as iitt;t::tj*.!i:i:ll.cr;tlr. These data :;r Le ;sed tbr countless ratios to measure corporate performance. The ratios used in th:s ierr are a sample of the major ratio categories used in business, but other classifr-

analysi s.

=;aioearnnl@r
l:-:-3ES firrr-3' -- -

---a--'l:''

.-.-i

neiteaiwt"v r r-*,tt' Llde: -l-t le

- ^ --:-.'-.': ----'t

:rl-

-'arrc5eistt ,55.fr6receilS :;; :: itei L:s<:*r :

,::j--E L' --'

:;1

tf,in.@rii -lardlitaFtslm( -1-:: :se:= ;: :-r':

-a
-

-----:.*-J_-

-:_=1r;;;
--i:^_ _--

-- =-':-:'.::--''

---*-r:--___

t:::. : ::r=: :'-: -i -i--:-:-. ' .

-'-1-' I L r: t,:.--.
--:!--: :

:-l':1-:t
:-i:
_-t_

-'

,-:

caaln

srstern,s can also be constructed.

:---:: !'-:

3 ;"-ie

Chapter

Financial Analysis

57

:ion and disins to appreciate

inancial ratios. didon to price a: net income greater mean-

Classification $ystern
We

will

separate 13 significant ratios into four primary categories.

A.

Profitability ratios.

rho does more

re examples in

1. Profit margin. 2. Return on assets (investment). 3. Return on equity.

irh only minor

B.

Asset utilization ratios.

per gallon; we
>al1

4. Receivable tumover. 5. Average collection period. 6. Inventory tumover. 7. Fixed asset turnover. 8. Total asset tumover. C. D.
Liquidity ratios.

players by

constructed to :. Lrut you must

9.

Currenl. ratio.

significance of erformance of

10. Quick ratio.

Debt utilization r4tios.

;ounts receiv:ea.ured only nphasize ratio

ed 550.000 on

11. Debt to total assets. 12. Times interest earned. 13. Fixed charge coverage.

: sarisfactory*ger 1 percent
tare our results

5rrformance

a;e. ard we are 1i.3rlv manage-

ustn data. For

r:siness. while i.'adons, Often

aicns to which
or ihe \ational

S-andard

&

s'.n3nt sun-eI.
d.a=base called

r:i:ies. ComPu'r-L\-ear period. . These data e :atios used il r arher classifi-

frrm's current ability to meet debt obligations. The bondholder, in turn, may be :u',marily influenced by debt to total assets-whiie also eyeing the profitability of the ::rrr in ternis of its ability to cover debt obligations. Of course, the experienced analyst rr:ks at all the ratios, but with different degrees of attention. R.atios are also important to people in the various functional areas of a business. lle marketing manager, the head of production, the human resource manager, and i.: ,x. must all be familiar with ratio analysis. For exampie, the marketing manager an:st keep a close eye on inventory turnover; the production manager must evaluate

The first grouping, the pru{iiuirilit-r ratios, allows us to measure the ability of the irm to earn an adequate return on sales.-total assets, and invested capital. Many ofthe troblems related to profitability can 6r! explained, in whole or in part, by the firm's :bility to effectively employ its resources. Thus the next category is cxsset w**lisatiqil.l ulios. Under this heading, we measure the speed at which the firm is tuming over *.counts receivable, inventory, and longer-term assets. In other words, asset utilization measure how many times per year a company sells its inventory or collects all of, =!ios ,5 accounts receivable. For long-term assets, the utilization ratio teils us how produc:r-e the fixed assets are in terms of generating sales. [n category C, the lirylidit3'rafiosn the primary emphasis moves to the firm's ability to :ay off short-term obligations as they come due. ln category D, etrebt xxfilipx*i**r nati<x, the -n;erall debt position of the frm is evaluated in light of its assot base and earning power. The users of financial statements will attach different degrees of importance to :s rbur categories of ratios. To the potential investor or security analyst, the critical :'nsideration is profitability, with secondary consideration given to such matters as -:quidity and debt utilization. For the banker or trade creditor, the emphasis shifts to

58

Part

Financial Analysis awl Planning

the return on assets; and the human resource manager must look at the effect of "fringe benefits" expenditures on the return on sales.
Ytu* &xaga&x

Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Saxton Company, as presented in Thble 3-1. The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

Financial statement for ratio analysis

: ,::',: , : '.:i:rr'l,:,.!t We first look at profitabilitl,-ratios. The appropriate ratio is com_ puted for the saxton company and is then compared to representative industry data.
,

Chapter3
Profitabililv ftsirclh -

FinancialAnalysis

59

. Net l. Hrolll'marqln income " Sales

. :::: :-

Saxton Company

lndusry Average
6.7%

= 5.k

2.

Relurn on assets (inveslment)

Net a._ income

: =-:-* 12'5Y"

Total assets

10%

.
3.

Net

income Sales Sales Total assets

Net income

5o/ox2.5:12.5%

6.77ox 1.5:1Ook

Return on equity =
a.

Stockholders' equity
Retum on assets (rnvestment) (1 * DebVAssets)

ffi=20% 0.125 _
I

15%
2076 0,10
1

- U.J/3

0.33

In analyzing the profitabilify ratios, we see the Saxton Company shows a lower feturn on the sales dollar (5 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 12.5 percent exceeds the industry norn of r0 percent. There is only one possible explanation for this occuffence-a more rapid :r.rrnover of assets than that generally found within the industry. This is verified in ratio lb, in which sales to total assets is 2.5 for the Saxton Company and only 1.5 for the :rdustry. Thus Saxton earns less on each sales dollar, but it compensates by tuming .:,ver its assets more rapidly (generating more sales per dollar of assets). Return on total assets as described through the two components of profit margin :trd asset tumover is part of the *-3* iiqrsi $}'${e,3l: &J r}{tirt\
.

Retum on assets (investment)

Profit margin

Asset tumovei

The Du Pont company was a forerunner in stressing that satisfactory return on assets be achieved through high profit margins or rapid tumover of assets, or a combina:on of both. We shall also soon observe that under the Du Pont system of analysis, the -*- of debt may be important. The Du Pont system causes the analyst to examine the ;rurces of a company's profitability. Since the profit margin is an income statement =iio, a high profit margin indicates good cost control, whereas a high asset turnover :a:io demonstrates efficient use of the assets on the balance sheet. Different industries

:ay

:.r'e different operating and financial structures. For example, in the heavy capital ;:rrds industry the emphasis is on a high profit margin with a iow asset turnover;:ereas in food processing,.the profit margin is low and the key to satisfactory retums :6 total assets is a rapid turnovet of assets. Equally important to a firm is its return on equity or ownership capital. For the Saxton l;'mpany, rethrn on equity is 20 percent, verslls an industry norm of 15 percent. Thus - owners of saxton company are more amply rewarded than are other shareholders in :: rndustry. This may be the result of one or two factors: a high retum on total assets or r lineronS utilization ofdebt or a combination thereof. This can be seen through Equa:-::- lb, which represents a modified or second version of the Du Pont fbrmula.

Chapter

Firnncia! Analysis

6t

::3sents the

..! !
:.-1j-F'-:--

Sales
r.ts:

l-.'.\.

:inr store chains, war-Mart and Macy's. rn 2007, upscale Macy's was more profit_ ::le in terms of profit margins (4.g percent versus 3.3 percent.) However, wal-Mart :ac a 21.6 percent return on equity versus 10.g percent for Macy's. why the reversal -: :erformance? It comes back to the Du pont system of analysis. war-Mart turned
: .'

-{s an example of the Du pont analysis, Tabre3-2 compares two well-known depafi_

-':s is not the case.

:r'ore quickly. wal-Mart was able to tum a 10w return on sales (profit margin) into a assets- Furthermore, its higher debt ratio (5g.g percent for wal-Mart ':rsus 49.9 percent for Macy's) allowed v/al-Mart to turn its higher return on assets -:io an even higher relative retur, on equity (21.6 percent versus 10.g percent). For ':rne hrms a higher debt ratio might indicate additional risk, but for stable wal_M;

\I;rt was following the philosophy of its rate founder Sam walton: Give the cusromer . aargain in terms of row prices (and row profit margins), but move the merchandise

ei iis assets 2.7 times a year versus a considerabiy slower

1 .

times for Macy's.-wal-

.,lrd return on

trehle

3*g

Return of Wal-Mart

versus Macyb using the Du Pont method of analysis, 2007

lairE'
i b1

u.,-3
p- --

ll

:". a 1 5 percent retum on newly purchbsed assets.

Finally as a general statement in computing all the profitability ratios, the analyst age of the assets. plant and equipment purchased 15 years ngo may be carried on the books far below its replacement value in an inflationary -onomy. A 20 percent return on assets-purchased in the early 1990s may be inferior

rust be sensitive to the

&$t8iix*tie*& K*rti*}ri* The second category of ratios relates to asset utilization, the ratios in this category may explain why one firm can turn ovgr its assets more =pidly than another. Notice that all of these ratios relate the balance sheet (assets) to :oe income statement (sales). The Saxton company's rapid tumover of assets is pri_ rarily explained in ratios 4, 5,'and 6.

& Asset

-d

Asst Util,aaiis$

Haftss*

4.

Receivables turnover Sales (credit)

Receivables

: :

Saxton Company

lndustry Average

..:'
:rl:

10

times.

5.

Average collection period Accounts receivable

-:11.4
i; ; ::
l

*"W
6.
Sales l"ventoty

oa"V CreO't.SateS

36 days

Inventory turnover =
lii I T:r*::m = to'a
:

::r.,1 :,

rrlil.

7 times

60

Part

Financial Analysis and Planning

initial version of the Du Pont formula (Return on assets : Net income/Sales X Sales/ Total assets). Return on assets is then divided by [1 - (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Saxton Company, the
modified version of the Du Pont formula shows: Retum on equity

Note the nufnerator, return on assets, is taken from Formula 2, which represents the

irtr As an example ot ghain5' \\-:-i ment store in performance? It

nu"r it, assets 2'7

-: able in terms of Proi 21.6 Percent r':*had a

;'-=

Retum on assets (investment) (1 - Debt/Assets)

dn:'

|-

l2.5%o :
0.375

2OVo

Mart was following tb: ot -t a bargain in terms Wal-\ImorJquicklY'

sood return on asseli'

Actually the return on assets of 12.5 percent in the numerator is higher than the industry average of l0 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Please see ratio 3b on
page 59 to confirm these facts. Both the numerator and denominator contribute to a higher return on equity than the industry average (20 percent versus I 5 percent). Note that if the frrm had a 50 percent debt-to-assets ratio, retum on equity would go up to 25 percent.l

iersus 49'9 Percefli ful! re1 into an even higher de some firms a higher
this is not the case'

Retum on equity

Return on assets (invesLment)

(1
12'57o

Debt/Assets)

l-

0.50

This does not necessarily mean debt is a positive influence, only that it can be used to boost retum on equity. The ultimate goal for the firrn is to achieve maximum valuation for its securities in the marketpiace, and this goal may or may not be advanced by using debt to increase retum on -equity. Because debt represents increased risk, a lower valuation of higher eamings i5 possible.z Every situation must be evaluated individually. You may wish to review Figure 3-1, which illustrates the key points in the Du Pont system of analysis.
Figure

FinallY as a generi must be sensitive to I ago may be carried economy. A 20 Perce

to a 15 Percent retul:
B. &$$*t &lt*?ization

$*t

Du Pont analysis

rhr! and the ratios in than anothe: raPidlY the income stateEei marilY exPlaineC;'

tu Asset Utilizatio'n 4e=-.e-re

Sat= :
=r_-=1."?

,li-3F li

t,--3$
lre+:)-,

a be sligirtly different than 25 percent because of changing financial costs with higher debt. 'Further discussion ofthis point is presented in Chapter 5, "Operating and Financial Leverage," andChapter 10, ''\aluation md Rates of Retum."

tf* ,"n*f

rr.gT j

fre*

a
62
Part

Financial Analysis and Planning

7. Fixed asset turnover

Sales
Fixed assets

Saxton Company

lndustry Average

llekt tllilixation Rat*l

1

$800"00s

5.4 times

1.

Debt to lotal asse: Total debt Total assets

8. Total asset turnover = Sales

Total 'dssets

qr 6nn

anO

2.5

1.stimes

12. Times interest ear

lncome before ir

ktg saxton coltrects its receivables faster than does the industry. This is shown by the receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by the average collection period of 32 days, which is 4 days faster rhan the industry norm. Please see these numbers in ratios 4 and 5 on page 61. The average collection period suggests how long, on average, customers' accounts stay on the books_ The saxton Company has $350,000 in accounts receivable and $4,000,000 in credit sales, which when divided by 360 days yields average daily credit sales of $11,111. We divide accounts receivable of $350,000 by average daily credit sales of $ll,11l to determine how many days credit sales are on the books (32 days). In addition the firm turns over its inventory 10.8 times per year as cbntrasted with an industry avetage of 7 times.3 This tells us that saxton generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efftcient inventory-itrdering and cost-control methods. The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry (5 versus 5.4) as shown above. This is a relatively minor consideration in view of the rapid movement of inventory and accounts receivable. Finally, the rapid tumover of total assets is again indicated (2.5 versus 1.5).
&- L*quXd*ty needs to examine the

--13. Fixed charge ccv( lncome before i

Fx(

Ratios for times ir Company debt is bei frrms in the indusnl-.

before interest and

ta

the stronger is tbe

ir

interest and taxes i 55 presented in the uPPe Fixed charge covt rather than interest Pi

cial obligation will

*ati*s

After considering prohtability and asset utilizarion, the analyst iiquidity of the firm. The Saxton Company's liquidity rarios fare

Company has lease o Thus the total fixed c income before aI1 Lr' aod taxes (oPeradng
irrco
Leas t^^^

well in comparison with the industry. Further analysis might call for a cgsh budget to determine if the firm can meet each maturing obligation as it comes due.-&i{'*tid!ty

ffiat*as*
:
saxton

The frxed charge

company
: 2.67

Indusrry Average

9. Current ratio

Current assets Current li'abilities

$80r,tcc
$3*0,cc0

5.5 times. The vario' sions reached in con valid, though excePt

2.1

10. Ouick ratio

Cunentassets-lnventory $4_3i1,0C0 :1'43 I-i -

cunentliabilities

1'o

sidered "good" unle: which may hurt futur In summary, &e S

saies dollar bY a raPi wise use of debt Th'

s. !3ckt lj{ll*xatism &xti** The last grouping of ratios, debt utilization, allows the analyst to measure the prudence of the debt management policies of the firm. Debt to total assets of 37.5 percent as shown in Equation 1l is slightly above the industry average of 33 percent, but well within the prudent range of 50 percent or less.
This ratio

financial pedormacc

Or-er the course of and ratio anal.vsis fc

may also be computed by using "Cost of goods sold" in the numerabr. While this offers some theoretical advantages in tems of using cost figues in both the numerator and denominator, Dun & Bradstreet and otber eredit reponing agencies generally show tumover using sales in the numerator

Therefore we look ai ever, without indusr picrure.

Chapter

Financial r\nalysis

iii::.l i,i:r .::l:: l.'r::t::--.',,

g:ext6*eerrlpany
- :'i
.o lLt;.. ?,SseLt --

indtlsts.y,Awere_qe

;sia, r.jellt ?otu*isern

= 37.5%

33%

-r139

int8re6l +erfted : lrrcrr-r* heicrle ir:tei'f5,i and t;ixes -i":nrcs,

-=

ll

Ttimes

: reit ch,i:0* Ltn\/drtU{

Ilgrry beFjglf "c,jlarJsl3lggleg ilixed fihar-E*s

:i

= :t

5.5 r:il'ilc$

:-ir:: i*l 'ii:nec irteresi eameii and i;xeei charge coverage sh{:iw t}rat the saxtein .' :"itt; debt ls heing i;/uli rflan6"geci ij{:}i1lperfi r1:o the ,:letrt 1nefiageuieng of other ',i :i.i !i'te indr:stii;. Tirnes ir:i:elesf earraeej nndi6;ates 1he nur,.rhe1 of iirnes tllat income - :'; anil taxes covers ihe interest c,hligation itr 1- tii::*s).'rile higi:er the raoc, ':iif,r-ilFii . :t:.,1go! is iile iuteresri-flr)./ing abitiCy ol' .che fir.n" Tlie 1ig.rli.,,. foii= incr,rme bef'oie : .-::t ii!.1 ialies i$ji5tl,00C) r;r t!:* latio is'rire equiv5.l66X of t.ho operaiing 1?r{rflt figilrr.j : .:ri*d ir:: ihe upirer ilart c,{'I'aiirXe 3--tr, back .}ft page 58. I '.ti charg': coveraga rneasilres lhe firr'n's ahiiitS' X61 rilee!- eli fir"cd obligat_ions ' ;: ihajn icterest ila,vtnen'es al6i?e, oi1 the assr,lrrlptiOn that tgiXu1:,e tC #?eet aq3i finall,i-;ligation ",vil? enclanger the positiori *f^ the fin:1. xn th* p::esent casl: the $ax-ton : r'?ri' ha$ leiisr': r:bligatilns of $5t),008 es weil ;rs ttrre $ji0,000 in inieresr sxrrsnses. . , .iic ii;tat fixed r,:iraige flna.*ciel *biigaricr rs $100,000. "f/e ;;,iso need {o l<lao'+ ihe .:.; i*fc:L"e ani l1v'ed ctra.rge: cbLip,aticris. I;i rhis cas* we L:jl{e income befcre lnter.osi . .,rrres (op*t:at.tne profit) and a*o. ba*k the $50,$*{J in j.ease prl_yrftej:its.
inr,cryle b*icli* intBresi :nci lar.e.
i,gFr$H Dsliii'r*!'tts

,{j55fl,t}ri0

5il,{}*il
$m0,J.0e rr

lri(;iln]e bef*rs fix*C ilhs!"ges a!l* i*xes

it.tod- *halges ai:f saf'eiij/ coveied 6 tirnes, exeeeding ilre in<lustryr norn1 of r:i"s. T'ht-, vaiia:1,.: raiir,:sr rj1'e summaftzed- ir'iahle'j'*j, *t-t !:rge i.1 'fhe cor;*,ii.r, :*a*hed ir c+iirp*"$ng';he sauoi: corrrpaily i;.1 inilusll-.- a'11.jragaira F,le gefi*i.ali,l, -, ir!.-r!i.gi-i excepiiolls rn;ly exlsi. F*r exanapie" a iris.h irir-,reLriiorv t$rr-rcrrei'is q:on-:;i "i1o+cl" unXess i'u Ls ef;iltrl'ed.'by nreirntainlng dnustjali-ri ilrv,r rnirentcii-ii ierrela,

-.tr

'

... iltz-il

iiur,i'; iu-ltt-iie s:lie-q ancJ

i r]l1il;r5lj/1 i.j:e ;taXtCn t-iOmpU.iry tnOle ijl;:$ itJlijFenSar"tet tCr a lC;r,,er rettl]rui

;.rlcfitability.

:1fi. thr:

'ri-;jls'trlyar"api*i(u'n{ivei:ci'e.s::leis,.qrinclpaiiyix}i/fiurfirlarrrlri:t;,eura"hl*s,a1lda : ,:: o.ir iei-rl.. 'li']t llltu:deni sh.*urLc ile ;.bie r-1, rrsr iilese i3 ixieasuititi,: ii_* rivfiilri:i_3 iite
,-,:rl .
e, f,Jl::rlafi(t{:.i

aif

a'fl..)/

jiiirn.

coutse c{'lilc irii:it'r*lqs cytig, satres anil pfcfiEehilli'?- ma,li +xlranrJ end contiilci,, a.nalt",qis flir aia.v ot.-rrJ Vert jrlai/ n{l[ !]realeni an ae*urafe p,icl.*r* ol tfue fij-rn. :'ii,rf- V,/g I*Cjr a-i, ilie ,lf perf*irnal'lce lr-t'e;i ix liumtrt-:; *f years. tr-1o",v irr:ut L-nduslrv r:otnp:-i.-isrrir; eve.m tiend anai-,;:;,is i:ruey not pie:teui a r:r:*rrlete
..il',

r.:lj

64

Part

FinancialAnalysis and Planning

?*&*s

$**

For example. l:

Ratio analysis

for the Saxton C'

itself may look gt

compared to indur average. With a::

though it is in a d, By comparing

32.0
10,8 5.0 2.5

time. In looking ; margins and retur is primarily due t' squeeze on profri.

1.43

Lou Gerstner toci ing matters aro'J:l, all-time highs i-r: of 2001-2002. ,\t head of the firm, :

37.5y"
6.O

ftstlra* 3*A
Trend analysis

Chapter

Financial Analysis

For example, in Figure 3-2 at the bottom of page 64, we see that the profir margin has improved, while asset turnover has declined. This by itself may look good for the profit margin and bad for asset tumover. However, when compared to industry trends, we see the firm's profit margin is still below the industry average. with asset turnover, saxton has improved in relation to the industry even though it is in a downward trend. Similar data could be generated for the other ratios. By comparing companies in the same industry, the analyst can analyze trends over time. In looking at the computer industry data in Table 3-4, it is apparent that profit margins and returns on equity have declined over time, for IBM, Dell, and Apple. This is primarily due to intensified cornpetition within the industry. IBM began to feel the squeeze on profits first, beginning in 1991. and actually lost money in 1993. By 1994, Lou Gerstner took over as chairman and chiefexecutive officer at IBM and began turning matters around; by 1997,IBM was back to its old levels of profitability and hitting all-time highs ior return on stockholders'equity. This conrinued until the recession of 2001-2002. At the end of 2002, Lou Gerstner announced he was stepping down as head of the firm. Since then, the company has maintained its profit margins.

for the Saxton company

iiriirt:::r::l:l:r::,ll
Margin

t:::rt:

i:li:i:::
Margin

:lt:,,:aa:::::l:::::1:

l::

Trend analysis in the

computer industry

Equity

Margln Equity

Equity

i:liii:rr:l:rlr::

1S88

9.8

147

9.8

39.9

ry

l:
,

x*s*{**r g*gt{f*i'fi
Finencial qnalysis is not onli/ rlone byr managers of tne flrm but by outsice analyst$ as weli. Theee outside analysts normally suppiy dat* !o stock market irrvestors.
t1

\:'

.lq9 negative ccrnment$ atrout iirms providins jnve$tn'|ent bailkiitg fes. Fity ihe poor investor who naively followed the advice o,

: _-:nrr*: i -_ _a:r:i-rr:r

::i

'*

-,-

r;
-

One of the probiems that was detecred after ihe gieal buli merket of the .f gg0$ vdas ihal analysts ulere not aiways as obieciir.,e as iherT should be. This uniortunate cliscorrery heiped intensiiy the bear market of the eariy 200*s. . The reason that manv analysts lack objectivity is that they rruork for irrvesrrnent banking* brokerage firms thai are not onjy invclved in pro.riding financial analysis for inl,,estors. but also underwfiting the sec,.lrilies of ttte {r!,ms they are covdiing. Underurrlting actirrity involves $e Cistribuiion of new securities in the pubrllc rnarhets and is highly prcfltable to thc investmen, O"-1", For exampie. Goldman Sachs. a ma;or Wali Streer investment bankjng firm. may not orjly be doing researeh anc financiai anaiysis on Generai l"loiors or Eastrnan Kodak, but aisc prolling from investment banking business wrth these rirryrs Since the fees from investmeni banking aCtivities contribute heavily to the overart operaiions ot lhe ;nvestment bankcr. nrairy analysrs ior invesinrent banking firms -r.eiaxed their standa"cs. In

doing financial analysis on their clients in the

1

990s.

As. ari example, Goldrp3n Sachs, Merrilf Lynch. or Smilh Barney often fditecl to dlvr,rlge potential weakiresses in the firn.ts they were investigattng foi fear of tr:sing the cl;snts ;nvestment banking business. Corporatiolls ir-lat were being rpcited upon were equaily quihy. lr4any a corporate cnief ofticer totd an inveslrnenl 'banker

that "if you come out wiih a negative

report, you will never.see anotfier dollar'$.worth

of our invesimeni bankirrg business.' Morgan

Stanley, a ma.i.r investment ba_nket, aotueliy had a written inlei.nal policy for analysts never

Morgan titanley during the nrri-1ggOs. After lhe marker crash of the early 2000s, tne SEC antj federai tegislators b,eOan requir:ng lnve$tment bankrs to eithei fui,ii separate their linancial anaiysis and undern'ritifig businoss ot, at a rnintmum, fully divulge an,v sLrch relaticnships. For example. Merritl Lynch now staies in its research teports, "lnvestors shoulcJ assume ihat Merriii Llinch is seeking or wilt seek investing banking or other business relaiionships v./jtn the companies in thjs report,' The government i.s also requiring investrnent bankers to provide independent reports to accompany thoir own in-house reports. These jndependent reports are done by fee-based research firms ihat do not engage in underurriting actrvrries. Independenitims inclLrJe Standard & Foor's, Value Line, Morningitar, and other srnaller jirrns, Tney tend 1o be totally objective and hard-hitting when neces$ary. ' Sofie inciependent research iirms kncw mcr'e af,out a company ihan it knows about itself. Take the example c'f Sanfcrd C. Bernstein & So. aird Cisco $ysterrs in late 2000, Bernstein analyst Paul Sagawr Cowng!.aded Cisco ior investment purpcses even though Cis;c Chief Sxeculive Officer John T. Cham, bers respectfutly disagreed. The astute independent andiysr anticipateci rhe enci cf the teleccm boom and krrely 16u disastrous effecl it would hsve on Cisco because ihe company woLl,J io$c key lelecom custonrers. When the disaster finatl]r cceltrrecl, eEO Charxbers told rnvestors that 'Nc one could nave predicted it. It was like a 100-year ilood. Apparently he forgot about the Sagawa repnrt he had read and dismissed cnly a feiii month$ befc,re.

B:iore. coin:tr:

::.Dlore the lr::,' :rS of the i-rr -:ihat nla]'misie.: a1d we shali ::,The majo: :r: in current dolla::
at lower pnc3 :;..

satisfacton

the 1990s and ::,

should be arr ar;

F.r

.rl iliit-lt:rl: "

The Stein Ccrp:.
end the firm
a1s.-

Cross profil.

Selling and adr DeBreciation.

.

Operating protli.
Taxes (40%) .
.

Aftertax income

Assume that :, However, inflaril,-

reillmiitg
6d

l.{} lirofitahilily with tts imrrovrng Frers$nal rorilFlrlter salcs, rts pgpgiar iFocl uigii;,ri iriisii: pliayers, and its iFiione !r Zi.l07.

The firrn i}:af suffe,red the inost lteady rlectrine was .Apprie colnputer, "\4rith act*al iosses in 1995 and 1997, and a threar cr banki-utrlrcy at thar tiine. !{owever, by 199g Apple h*d niiraculously t*rneC itself arr:und ix/ith a lucrative new line of L4aciotosl,l rlesktoxr ecmputers anel its profit mangins *n{: .retilx-ils ou ec}ujty were v,rell inio the hiack: again. Iiowever, .Ag:ptre trlr.r su{'ier*cl during rl:e rressiorl of ?00tr*2[J02 liefore

De1l Conlputer.dic not come iirt$ the pict-ure u*tii 1992, and liacl showil very strong leveis of perf,onnanee r:rltii 200f-r. F**l-lciler I4jcliael Dell, a billionaire, had to once again assuma the role as cFiL\ io trl, ic il'prove the cc*pairy's nurrber.s.

wili go up to Sii . purchased will be

volume. Further.
shown in Thbie
I'i:;.ll:ll.'L:llt,rl.t

written off agarnsl In Table 3-6. r|:

3-:
.

is the increased cc's

As mentioned r:. the FASB for larg: tary. What are the l of 10 chemicai firn

Chapter

Financial AnalYsis

67

I l

What will be the trends for all three companies for the rest of the decade? Technology is changing so"quickly that no one can say. All three are likely to remain lean in terms of operating expenses, but highly innovative in terms of new product development.

Before, coincident with, or following the computation of financial ratios, we should explore the impact of is*!'';rti*:l and other sources of distortion on the financial reportur! of tne firm. As illustrated iil this section, inflation causes phantom soulces of profit may mislead even the most alert analyst. Disinflation also causes certain problems
':Uat

&mpa**

xx
ggx

$an$8at$wsx

S*axsm*$*x$

&:aa$ys&w

:.- 1:il :r
ui'

and we shall consider these as

well' The major problem during inflationary times is that revenue is almost always stated

i
n

purchased :n cuffent dollars, whereas plant and equipment or inventory may have been Thus, profit may be more a function of increasing prices than of 3t lower price levels.

fl

t
?
qil

! --rEft

most of satisfactory performance. Although inflation has been moderate throughout you and the current decade, it tends to reappear in almost every decade so :e 1990s :rould be aware of its consequences.

{
ll
$l

ln
{ ::BlF ': {;]@

ii!*stra;am

E tl

lae Stein Corporation shows the accompanying income statement for 2008. At year:rd the firm also has 100 units still in inventory at $1 per unit'
T*il*le

l!

54

t
t
i I

t
+ffi lF.

t' l
I
1

i
I

- :rien"
-le T@
::at[p

!-s $fr@

'r',rg'ft :5m !ffil{ }lliffi si. h1G 'ffin W

,issume that in the yeat 20a9 the number of units sold remains constant at 100. --.-;. ever, inflation causes a l0 percent increase in price, from $2 to $2.20. Total sales ., ' go up to $220 as shown in Table 3-6, but with no actual increase in physical t -ne. Further, assume the firm uses FIFO inventory pricing, so that inventory first ::::lased will be written off against current sales. In this case, 2008 inventory will be

,,:::n off against

.
:

.,ti,

ll

-l

year 20A9 sales revenue. Table 3-6, the company appears to have increased profit by $ 1 1 compared to that ,: : . : in Thble 3-5 (from $42 to $53) simply as a result of inflation. But not reflected plant and equipment. Presumably, their -- . :ncreased cost of replacing inventory and an inflationary environment' :iir*xi$, l*i;1s have increased in --j mentioned in Chapter 2, inflation-related information was formerly required by :* :-{SB for large companies, but this is no longer the case. It is now purely volun-ihat are the implications of this type of inflation-adjusted data? From a study - :hemical firms and eight drug companies, using current cost (replacement cost)

y -

68

Part

Financial Analysis and Planning

Tahle

financial lOK statements which these companies filed with the Secuin ^fable3-7 rities and Exchange commission, it was found that the changes shown
data found in the

occurred in their assets, income, and selected ratios'4

}?a&te

3*?

iiiiicls::rrr::t:itrtr:

Comparison of rePlace' ment cost accounting and hi$torical cost accounting

$eiia!il: ::i:l penec :: i , huri l:,- -' : *' .:

in the The comparison of replacement cost and historical cost accounting methods replacement cost reduces income but at the same time increases assets' table showsihat asset that This increase in assets lowers the debt-to-assets ratio since debt is a monetary debt-to-assets is not revalued because it is paid back in current dollars. The decreased look at the ratio would indicate the financial leverage of the firm is decreased, but a Because the interest coverage latio meainterest coverage ratio tells a different story. declining income sures the operating income available to cover interest expense, the the firm has decreased its ability to cover its interest cost' penalizes this ratio and
f;isiiditrticcr{ frfqe*t profits appear to feed As long as prices continue to rise in an inflationary environment, that when price increases moderate (eiisi*{3*" on themselves. The main objection is tir;x), there will be a rude awakening for management and unsuspecting stockholders A 15 or 20 percent as expensive inventory is charged against softening retail prices.
nl"ff C"-"U for Ceoffrey A. Hirt, "Replacement Cost Data: A Study of the Chemical and Drug Industry used as a .ough v"*, t szo tt ""0 1 978." Replacement cost is but one form of cunent cost. Nevertheless, it is often measure of cunent cost.

The eti;:'

r*:-:- : treatn;:.. .:
COpe

financ'- :: -.
staterne:-'i

..

"

Bcth :-r:::.
COnSeI"':- :

- r'-

reporie:::-.*'

-: PanYBli---: $700,0':d. we have r::.:

If boi:- :

xp!*naiii:
Let us
are not

:*

er.:: :.
.

to a numb.::

i1':.,

Chapter3

FinancialAnalYsis

69

growth rate in earnings may be little more than an "inflationary illusion'" Industries most sensitive to inflation-induced profits are those with cyclicai products, such as .umber, copper, rubber, and food products, and also those in which inventory is a signlficant percentage of sales and profits. A leveling offofprices is not necessarily bad. Even though inflation-induced corpo:ate profits may be going down, investors may be more willing to place their funds in hnancial assets such as stocks and bonds. The reason for the shift may be a belief that jeclining inflationary plessures will no longer seriously impair the purchasing power ,:f rhe dollar. Lessening inflation means the required return that investors demand on :rnancial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current valuation' None of the above happens with a high degree of certainty. To the extent that invesiors question the permanence of disinflation (leveling off of price increases), they may

c*

:rot act according to the script. That is, lower rates of inflation will not necessarily lroduce high stock and bond prices unless reduced inflation is sustainable over a rea.-.nable period. Whereas financial assets such as stocks and bonds have the potential (whether real(real) .zed or not) to do well during disinflation, such is not the case for tangible Plecious metals, such as gold and silver, gems, and collectibles' that boomed in lssets. :re highly inflationary environment ofthe late 1970s fell off sharply a decade later, as ;oftening prices caused less perceived need to hold real assets as a hedge against infla:ion. The shifting back and fo'rth by investors between financial and real assets may rccur many times over a business cycle.

ir-:i:i:t'l!g* There is also the danger of **il*{i*n, actual declining prices (which hap:ened in Russia, Asia, and other foreign countries in 1998), in which everyone gets iurt from bankruptcies and declining profits.

he effect

of changing prices is but one of a number of problems the analyst

evaiuating a company. Other issues, such as the reporting

must

:Llpe with in '-:eatment of nonrecurring items, and the tax

of revenue, the

write-off policy, cause dilemmas for the analyst. The point may be illustrated by considering the income :nancial manager or ,:atements for two hypothetical companies in the same industry as shown in Table 3-8' 3cth firms had identical operating performances for 2009-but Company A is very its : tnservative in reporting its results, while Company B has attempted to maximize
:ported income. if both companies had reported income of $280,000 in the prior yea-r of 2008, Com:any B would be thought to be showing substantial growth in 2009 with net income of ! =00,000, while company. A is reportin g a "flat" or no-growth year in 2009. However,
,.

#t&*r K$*e$e*${s wf S$***rt8** 8m ffi*pw**d &s**srYs*

e have

already established that the companies have equal operating performances.

!:.

, e., )r.;' 1lr "ii

,er us examine how the inconsistencies in Table 3-8 could occur' Emphasis is given
.:, a number of key elements on the income statement. The items being discussed here

,::

not illegal but reflect flexibility in financial reporting.

,i &t

70
Ti!&!* s*&

Part

Financial Analysis and Planning

Gcb
Puse

A!

Co4 ilfer ti}e si {ww}t

frm as

reFti
is

he*a
*irotta
bankS{

cofip

iwith sr*

fnsrn
hofn
gives key peratn

SE TE

.'ii:lirtii:ll:{iill:iaritv ot

fi

ra

.l::liliill:ieomPanY ter t :::::ir:t:,::]:. :iri:i8g to colr Company B reported $200,000 more in sales, although actual volume was the of different concepts of revenue iecognition. For example, certain assets pay be sold on an installment basis over a long period. A conservative firm may defer recognition of the sales or revenue until each payment is received, while other firms may attempt to recognize a fully effected sale at the earliest possible date. Similarly, firms that lease assets may attempt to consider a long-1e.to lease as the equivalent of a sale, while more conservative firms only recognize as revenue each lease payment as it comes due. Although the accounting profession attempts to establish appropriate methods of financial reporting through generally accepted accounting principles, there is variation ofreporting among firms.
same. This may be the result

$s{*s

.ilr::i::i,::r:t.r:li.itb, ltlr,i:tttrit:,,Flb,
l:,llll::i:,:ri:t,::
' .

RateFtrr

,,lii'tl:rll:rrilli:ll{t:ispy

Krer*

jng" is prsfic

:,:,,]:::tltt:::,::aCccunting
rri.::rr,:r,:..ChiSS

' 2. 3.

and resentes ha l

tiPulalirg fir Poteatbl ftna ofconcern m tributons to { AdequacYol

&s*ds $s** The conservative firm (Company A) may well be using f,iF'{i} accounting in an inflationary environment, thus charging the last-purchased, more expensive items against sales, while Company B uses S{F$ accounting*-charging off less expensive inventory against sales. The $300,000 difference in cost ofgoods sold may also be expiained by varying treatment of research and development costs and other items.
Ssx** c$ [Htrao{dssEasy fii}tex$Ilo$se$ Nonrecurring gains or losses may occur from tJre sale of corporate fixed assets, lawsuits, or similar nonrecurring events. Some analysts argue that such extraordinary events should be included in computing the current income of the firm, while others would leave them off in assessing operating performance.

ls the cor4* knefit of stt agement? A

optbns bein

trulY indepc{ Board d l*n

attivitles ol'l

Extraordinan.

Unfortunately, there is inconsistency in the way nonrecurring losses are treated despite attempts by the accounting profession to ensure uniformity. The conservative Firm A has written off its $100,000 extraordinary loss against normally reported income, while Firm B carries a subtraction against net income only after the 9700,000 amount has been reported. Both had similar losses of $100,000, but Firm B's loss is shown net of tax impiications at $70,000.

( 1ou might thir}l. decade. In the ;-: frner points o: ::;:

Hel lncome Fiim A has reP:::.

traction of erE:a'--: gls of financiai re;

Frlbrmance

ha*c ;

::;h item ill the i

r:.

:'

t:

Extraordinary gains and losses happen among large companies more often than you might think. General Motors has had "nonrecurring" losses four times in the last decade. In the current age of mergers, tender offers, and buyouts, understanding the finer points of extraordinary gains and losses becomes even more important. Fl*t lm*omrs
Firm A has reported net income of $280,000, while Firm B claims $700,000 before subtraction ofextraordinary losses. The $420,000 difference is attributed to different methods offinancial reporting, and it should be recognized as such by the analyst. No superior performance has actually taken place. The analyst must remain ever alert in examining each item in the financial statements, rather than accepting bottom-line figures.

7I

Pirt:Z,.

,,

financiizl Analysis and Planiing

S$m$eerw

natio'analysis allows the anai:ysl io Compare a cornpanyrs'perforrnance ta that of oth= ers,in itS industry.: Ratios that iqiti4lly appear,good ol .bad may not retain ihat characteristic when measured against industry peers6-l There are four main groupings of ratios. Pr\ifitability ratios measure theiFrm's ability to earn an adequate return on sales. assets, and stockholders' equity. Thb*'sset utilizationiali6stell,the'anabst how quickly;lhe firm is lurolng oyerlts accqunts {eceivable, rability: to pay otT inventory; and,longe!,-trm urr"tr. Liquffitty pSpios nreaqpre ttre finn'i due, and$dtt utitizationratios,indicate lhe overall shqrt lerm,obJlgations.qq,,thgy cgme. debt position of ,ths finn in li$, of it5 asse! ba-se' aild -earnitlg porller. The'Du P;ti'sy:gtem of anal;r,sis firgt breaks dewn retur,n'on assets,between the profit,margirt and,4ssetllurngver',lherSeCond gtep then shows how this retum on assets iS tranSlated,into:retUrn on qulty through the amount of debt the firm has. Throughout the analysis, the analyst can better understand how return on assets and return on
,

6. Why

is trend an can h:'

7. Inflation

and therefore o: on the follo*ii; assumPtions ''-

.. a, Retum

on

b" c. d.

lnventoq' :'
Fixed a:se: Debt-ro-as'

8. What efieci ''i:'

rePorted inc'lr:

9. WhY might c:.:

equity are derived. Over the course of the business cycle, sales and profitability may expand and contract, and ratio analysis for any one yeaf may not present an accurate picture of the firm.'Therefore we,look:at ihe irend analysis of perforrrnance,over a period of years. A number of factors may distort the numbers the accountants actually reporl. These iirclude ihe effect:,of,in{lation ot disinflation, the timing of the recognition of sales as ievenue, ttri, treatrnent of inventOry Wrile-offs-;11he presence of extraordinary gains and losses; arrd so on T&e well,trained-financial analysl muSt be'alert to all of these factors.

i0.

ComPariscrs : theY sell the s.:

l.

Bames APP1:.:

of $4,000,C'l::-

List ef Yerffis

prolitahility *at!*$ 5J e$$el {rtilk$tiorl raiitw..- 57 '

,,

infiati*sr 6'l
reg:1*cerner*t**!sts 67
'

a. b. c. d. 2.

Whar is ::. What

i'

::

What is :The cieb:-r

tiq*i*ity rntios 57 ' *ich.t utilissfi{!$ r{}tit'}s 57 !]u licwt syslen: of *li*lysis tlend unallsis 63
Si*sru*sicn &$asttclts

etrlsirrf3*{i*n 68 deflaslaar 69

wouic :r: the ter:

59

l,x,F*
sxp{:}

The Giilian J
Pute the

70 ?0

Ptci:

1,

Ifwe

diVide users ofratios into short-terffi lenders, long-term lenders, and stockholders, which ratios would each group be ,ftosf interested in, and for

whal reasonq? 17gi2S ' 2. Explain how the Du Pont syEtem of analysis breaks down retum on assets. Also explain how it breaks down return on stockholders'equity. (LO3) 3. If the accounts recgivable tur-nover ratio is decreasing, what will be happening to the average collection pet',od? (LO2)

lfrhat advantage does the fixed charge coverage ratio offer over simply using
times interest carned2 (LOT) 5. Is there any validity in rule-of-thumb ratios for all corporations, for example, currenr ra:io of2 to 1 ordebt to asssts of50 percent? (L02)
a

6. Why is trend analysis helpful,in,analyziwgratios?

(LO4)

'

,,

7.

,'asSumptjons.(L05)

Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the followingratios, and explainr the direction of the lmpait based on your

r. :',..
.,

, ,

,,,
.,,1... ..

a. ;. b,
..,c.,

Retum on investment
InventO.rytur.n0vefr
.

, i. ri r,.. : ..

FiXed,:asgettg,fnoyef

'. . .1 , 8. What effect will disinflation following a highly inflationary period have on the
ps!1;to-assets

. 6f
,

r..: tt. .,..., .

...., .

,,

,,,

..1,,..,.

,',

...

i.

ratio

, : ,1.. ...
:

9" W-hy, m.ight disiaflation:p{ove to be:faYorable to finaneial assels? (/,O5) 10. Comparisons of income can be very dilficult for two .ornpuni". even though ihey sellrthe sarne producls in eQua! volume.'Why? {LOZ)'
,

reported ineome of tle,fqm?

(LOs)

,''

, t

'

Frac'&tse BarnesApbllanceshas sales sf $10,000,008, netincome,of $450,000;:total assets

Prablry_ms *xr$

of$4,000'000,andstockho1ders'equity.of$2,000,000.:..

Ss8srg5ox?s

a. b. c. d

What is the profit margin? What is the return on assets? What is the return on equiry? The debt-to.as5et$ ratio is currenlly 50 percent. If it were 60 percent, what would the return on eguity be?'to answer this question, use formula 3D in
the text.

Frofrmbility ratios

ars:]

The Giiliam Corp. has the,following balance sheet and income'statement. Compute the profitability, asset utilization, liquidity, and debt uiilization ratios.

All
{

n3 ralirrs
}

t-{.};

GILLIAM CORPORATION 'Balance Sheet Decembei 31,200x

Assets ..
Current assels:

Cash...
Marketable securities Accounls receivable (net) . . lnventorv
Tolal current assets . . "
. .

70,000 40,000 250,000 200,000

$
.. . ;. . ..
.

560,000 100,000 440,000

lnvestments. Net plant ind.equipment. . . . .

Total assets.

$1,100,000

continued

Pan

Fiwancial A,na,lysis and Flanning

Liabilities eftd St*ekhole*er' Hquity

Crjrcnt liebilitie$:
Aecoutltg payablP itots$ payfible.
Accrucci
"

13t,0*r1

1t0,c00
$0,+s1l

r.

taxes .

'tutal Eurrent liabililies Long-term liabilities: Eonds payable

Total

$ r$*,0s0
3fi0,00*

llabilities v&li,s

.. $

480,{}00

Slockha!ders' equiryFr*ferred stonk, $100 pilr

5t.000
50,000

ecrnnre* s:ock, $5 par vafue Capita: $]aid iii excess of par. . .

fteteifted

200,$S0

ariling.e.
"

_j?q{qq
620,0cl]

Tatal stockholtJers' equit).

Total liabilitiec anel stoekholders'equl?t' . . .

$i$gge

GltLtAffi eSPFOffisATlSFi
fnc6me Statnnemt
F(rr lhe Vear

ilnr*ng ileceanbes

31 ,

2[}$X

Sales {ancredit}.. .. . " Less: Ccst ol goods sola.

. .
.

$2,4A0,S00

Gross pr0f:t Less: $eliing and adnnin;strative expenees " .

Operatircg prafjt {SlT} " , Less: Inte";-st experise
.

..

-.

. .
" .

tfqgf#q
e*6,ss0
5SS,*rr0-

*,$0,*Sfl

.
.

3$.*0s
2't

arnings b*tore laxes iE$T) .

Less: Taxes

*,*il0

75,0ilc

tarnings after iar,es (LAl)

.lneludes

I35"3tli

$40,00S in i-Aase pa!,m6nt$.

:l:i,::!:;:::..\

1. &. &ofit rn*rgin : h'Tetincoa'i:e $45*"$ffi) : 4"5Vo Sales 51&,*10$,**0 b. Return on assets : F{et iircorne $458"*0e : 1 t |,<q^
Toiaiassets
Net 54,0{}fi,0$S

{:. d.

Return s$ eqrrity

Retum on eqarity

ini:omr , ;:.., i1 '; - t,.1,:.4 Slockholders'cq,:'ly' -',r,i -',i Retui:n *n assets {i.ni,estfil*ri) 1 1.?5%
{n
11 1qq..
.4

*ebtlAsse:si
14" t )'/C

il

"

2" Prefitairiiity rsti*s S:li.ndi i. R'cfit*argin : lJ*t:1"rry _ 2.4.1{1,0il0 :

$aies

5./:

iii.

lr,

Chapter

-4

Financitsi Antiirsis

2.
3.

Refirm on assets
Return an equity

: :

Net income Total

:-:=--

assets
Net

$135'ooo
i,100,000
--:* -

t2.Zla/a

income

5135,000
620.000

Stockholders'equity

* -

.jt 1-n
-t'tt
I

Asset utilization natios

4.
5.
6.

Receivables tumover

Sales {credits)

$2,400,000

Accountsreceivable 250,ii00

v"ox

Average coliection period

Aecounts reeeivatrlo

Avg. daily credit sales

$2,4_o0r_otx) 200,CI00

$2s0"00{i : 6,667

-)

i.) ialS

Inventorv lumover '

Sales

Inventory
Saies

_ ttx

7. Fixeci asset iurnover

$?:400,0CI9

Fixed assets

440,000

5.45x

Toral asset tumover

: *

s49u
assets

Tolal

$2,4$0,00u - i la1,100,0*0 560,000 280.000

tiquidity ratios

9.

Current ratio

Current assets
Curuent liab!lities

10. Quick ratio

Curreni assets

lnveniory

$i9-O,Sqg_

jzuqq

Curent liabilities

280" 000

360,000
280,000.

_
-

1 4n_. I.La^

Detlt utilization ratios

1r.

Debtrororaiassets

: ffi
:
-- ?19.goq
30,00CI

: fffiffi : 43
Interest

64vo

12. Times interest earned

Income befone in{erest an<{ ta,xes

Iy'ote: Income trefore interest aild taxe$ equals cperating pn:f?t, $240,11S0.

Times inrcresr earned

R*

13. Fixedehargecoverags

irrcome before fixed charges a-nd taxes

Fixed;#--:
{J}perating pro{it plus Lrase payrnentr*

lncome before fixed che,rges a.nd taxes

+ $40,s00 : $280,s0CI Fixed charger = Lease paymenis + trnteffst $40,000 + $3CI,0ii0 : $70,000
$240,000
Fixed charge colJe.age =
{Lease paymen;s

$280,000 ?0,000

:4x

ue ir

a foiltnote on ihe

iacoffr stalemer!