Solutions to Chapter 17

Financial Statement Analysis

1.

2.

7,018
0.42
7,018 9,724

a.

Long-term debt ratio

b.

Total debt ratio

c.

Times interest earned

d.

Cash coverage ratio

e.

Current ratio

f.

Quick ratio

g.

Operating profit margin

h.

Inventory turnover

i.

Days sales in inventory

j.

Average collection period

k.

Return on equity

1,311
0.139 13.9%
(9,724 9,121) / 2

l.

Return on assets

1,311 685
0.072 7.2%
(27,714 27,503) / 2

m.

Payout ratio

4,794 7,018 6,178

0.65
27,714

2,566
3.75
685

2,566 2,518
7.42
685

3,525
0.74
4,794

89 2,382
0.52
4,794
1,311 685
0.151 15.1%
13,193

4,060
19.11
(187 238) / 2
(187 238) / 2
19.10 days
4,060 / 365
( 2,382 2,490) / 2
67.39 days
13,193 / 365

856
0.65
1,311

Gross investment during the year

= Increase in net property, plant, equipment + depreciation
= ($19,973 $19,915) + $2,518 = $2,576

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3.

Market-to-book ratio = $17.2 billion/$9.724 billion = 1.77

Earnings per share = $1,311 million/205 million = $6.40
Price-earnings ratio = $17.2 billion/$1.311 billion = 13.1

4. Balance sheets for Phone Corp:

Dollar amounts
End of year Start of year
Assets
Cash&marketablesecurities
$ 89
Receivables
2,382
Inventories
187
Other current assets
867
Total current assets
3,525
Net property, plant, and
equipment
19,973
Other long-term assets
4,216
Total assets
$27,714
Liabilities and Shareholders Equity
Payables
$ 2,564
Short-term debt
1,419
Other current liabilities
811
Total current liabilities
4,794
Long-term debt and leases
7,018
Other long-term liabilities
6,178
Shareholders equity
9,724
Total Liabilities &
Shareholders equity
$27,714
5.

ROA

Common-size (% amounts)
End of year Start of year

$ 158
2,490
238
932
3,818

0.32%
8.59%
0.67%
3.13%
12.72%

0.57%
9.05%
0.87%
3.39%
13.88%

19,915
3,770
$27,503

72.07%
15.21%
100.00%

72.41%
13.71%
100.00%

$ 3,040
1,573
787
5,400
6,833
6,149
9,121

9.25%
5.12%
2.93%
17.30%
25.32%
22.29%
35.09%

11.05%
5.72%
2.86%
19.63%
24.84%
22.36%
33.16%

$27,503

100.00%

Net income interest 1,311 685

0.0723 7.23%
Average total assets
27,608.5

Asset turnover

Sales
13,193

0.4779 47.79%
Average total assets 27,608.5

Operating profit margin

Net income interest 1,311 685

0.1513 15.13%
Sales
13,193

Asset turnover Operating profit margin = 0.4779 0.1513 = 0.0723 = ROA

6.

100.00%

1,311
1,311

0.1391 13.91%
(9,724 9,121) / 2 9,422.50

a.

ROE

b.

Assets
Sales
Net income interest
Net income

Equity Assets
Sales
Net income interest
27,608.5
13,193
1,311 685
1,311

0.1391 13.91%
9,422.5
27,608.5
13,193
1,311 685

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7.

8.

9.

a.

(Notice that we have used average assets and average equity in this solution.)
The consulting firm has relatively few assets. The major asset is the knowhow of its employees. The consulting firm has the higher asset turnover ratio.

b.

The Catalog Shopping Network generates far more sales relative to assets
since it does not have to sell goods from stores with high expenses and
probably can maintain relatively lower inventories. The Catalog Shopping
Network has the higher asset turnover ratio.

c.

The supermarket has a far higher ratio of sales to assets. The supermarket itself
is a simple building and the store sells a high volume of goods with relatively
low mark-ups (profit margins). Standard Supermarkets has the higher asset
turnover.

a.

Debt-equity ratio

Long- term debt

Equity

b.

Return on equity

Net income
Average equity

c.

Profit margin

d.

Inventory turnover

e.

Current ratio

f.

Average collection period

g.

Quick ratio

Net income interest

Sales
Cost of goods sold
Average inventory

Current assets
Current liabilities
Average receivables
Average daily sales

Cash marketable securities receivables

Current liabilities

If Pepsi borrows $300 million and invests the funds in marketable securities, both
current assets and current liabilities will increase.
a.

Liquidity ratios
Current ratio
Quick ratio
Cash ratio

5,853 300
1.16
4,998 300

1,649 2,142 300

0.772
4,998 300

1,649 300
0.410
4,998 300

The transaction would result in a slight decrease in the current ratio and an
increase in the quick ratio and the cash ratio, so that the company might
appear to be more liquid. However, a financial analyst would be very unlikely

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b.

to conclude that the company is actually more liquid after engaging in such a
transaction.
Leverage ratios
The long-term debt ratio and the debt-equity ratio would be unaffected since current
liabilities are not included in these ratios. The total debt ratio will increase slightly,
however:
Total liabilities 13,047 300

0.607
Total assets
21,695 300

The very slight increase in the total debt ratio (from 0.601 to 0.607) indicates that
the company would appear to be very slightly more leveraged. However, a financial
analyst would conclude that the company is actually no more leveraged than prior to
the transaction.
10.

a.

Current ratio will be unaffected. Inventories are replaced with either cash or
accounts receivable, but total current assets are unchanged.

b.

Current ratio will be unaffected. Accounts due are replaced with the bank loan, but
total current liabilities are unchanged.

c.

Current ratio will be unaffected. Receivables are replaced with cash, but total current
assets are unchanged.

d.

Current ratio will be unaffected. Inventories replace cash, but total current assets are
unchanged.

11.

The current ratio will be unaffected. Inventories replace cash, but total current assets are
unchanged. The quick ratio falls, however, since inventories are not included in the most
liquid assets.

12.

Average collection period equals average receivables divided by average daily sales:
Average collection period

6,333
236 days
9,800 / 365

13.

Days sales in inventories

400
2 days
73,000 / 365

14.

Annual cost of goods sold = $10,000 365/30 = $121,667

Inventory turnover

121,667
12.167 times per year
10,000

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15.

a.

Interest expense = 0.08 $10 million = $800,000

Times interest earned = $1,000,000/$800,000 = 1.25

16.

Cash coverage ratio

c.

Fixed payment coverage

a.

ROA = Asset turnover Operating profit margin = 3 0.05 = 0.15 = 15%

b.

If debt/equity = 1, then debt = equity, so total assets are twice equity.

ROE

17.

1,000,000 200,000
1 .5
800,000

b.

1,000,000 200,000
1.09
800,000 300,000

Assets
ROA Debt burden
Equity

2
20,000 8,000 8,000
0.15
0.10 10%
1
20,000 8,000

Total sales = $3,000 365/20 = $54,750

Asset turnover ratio = $54,750/$75,000 = 0.73
ROA = Asset turnover Operating profit margin = 0.73 0.05 = 0.0365 = 3.65%

18.

Debt-equity ratio
0 .4

Long-term debt
Equity

Long-term debt
$1,000,000

Long-term debt = 0.4 $1,000,000 = $400,000

Current assets
2.0 and Current assets = $200,000
Current liabilities

Therefore, Current liabilities = $200,000/2 = $100,000 = Notes payable

Total liabilities = $500,000
Total assets = total liabilities + equity = $500,000 + $1,000,000 = $1,500,000
Total debt ratio = $500,000/$1,500,000 = 0.33

19.

Book Debt
0.5
Book Equity

17-5

Market Equity
2
Book Equity
Book Debt
0.5

0.25
Market Equity
2

17-6

20.

EBIT = Revenues COGS Depreciation

= $3,000,000 $2,500,000 $200,000 = $300,000
Interest = 8% of face value = $80,000
Times interest earned = $300,000/$80,000 = 3.75

21.

The firm has less debt relative to equity than the industry average but its ratio of (EBIT
plus depreciation) to interest expense is lower. Perhaps the firm has a lower ROA than
its competitors, and is therefore generating less EBIT per dollar of assets. Perhaps the
firm pays a higher interest rate on its debt. Or perhaps its depreciation charges are lower
because it uses less capital or older capital.

22.

A decline in market interest rates will increase the value of the fixed-rate debt and
thus increase the market-value debt-equity ratio. By this measure, leverage will
increase. The decline in interest rates will also reduce the firms interest payments on
the floating rate debt, which will increase the times-interest-earned ratio. By this
measure, leverage will decrease. The impact of the lower rates on leverage is thus
ambiguous. The firm has higher indebtedness relative to assets, but greater ability to
cover its cash flow obligations.

23.

a.

The shipping company, which has more tangible assets, will tend to have the higher
debt-equity ratio. (See Chapter 15, Sections 15.3 and 15.4, for a discussion of the
reasons that firms holding tangible assets with active secondary markets tend to
maintain higher debt-equity ratios.)

b.

United Foods is in a more mature industry and probably has fewer favorable
opportunities for reinvesting income. We would expect United Foods to have the
higher payout ratio.

c.

The paper mill will have higher sales per dollar of assets. It is less capital intensive
(that is, has less capital per dollar of sales) than the integrated firm.

d.

The discount outlet sells many of its goods for cash. The power company bills
monthly and usually gives customers a month to pay bills and therefore will have the
longer collection period.

e.

Fledging Electronics will have the higher price-earnings multiple, reflecting its
greater growth prospects. (Recall from Chapter 6, Section 6.5, that the P/E ratio is
an indicator of the firm's growth prospects.)

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24.

Leverage ratios are of interest to banks or other investors lending money to the firm.
They want to be assured that the firm is not borrowing more than it can reasonably be
expected to repay.
Liquidity ratios are also of interest to creditors who prefer that a firms current assets are
well in excess of its current liabilities. Liquidity ratios are especially important to those
who lend to the firm for short periods, for example, by extending trade credit. If a firm
buys goods on credit, the seller wants to know that, when the bill comes due, the firm will
have enough cash on hand to pay it.
Efficiency ratios might be of interest to stock market analysts who want to know how
well the firm is being run. These ratios are also of great concern to the firms own
management, which needs to know if it is running as tight a ship as its competitors.

25.

Income Statement
Millions of dollars
Net sales
$199.93
Cost of goods sold
120.00
Selling, general & administrative expenses
10.00
Depreciation
20.00
EBIT
49.93
Interest expense
6.27
Income before tax
43.66
Tax
30.13
Net income
$ 13.53
Balance Sheet
Millions of dollars
This year
Last year
Assets
Cash and marketable securities
Receivables
Inventories
Total current assets
Net property, plant, equipment
Total assets

$ 11
44
22
77
38
$115

$ 20
34
26
80
25
$105

$ 25
30
55
24
36

$ 20
35
55
20
30

$115

$105

Liabilities & Shareholders Equity

Accounts payable
Notes payable
Total current liabilities
Long-term debt
Shareholders equity
Total liabilities &
Shareholders equity
Solution Procedure:

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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.

Total current liabilities = 25 + 30 = 55

Total current assets = 55 1.4 = 77
Cash = 55 0.2 = 11
Accounts receivable + cash = 55 1.0 = 55
Accounts receivable = 55 cash = 55 11 = 44
Inventories = 77 11 44 = 22
Total assets = Total liabilities and Shareholders equity = 115
Net Property, plant, equipment = 115 77 = 38
Cost of goods sold = Inventory turnover Avg. inventory = 5.0 (22 + 26)/2 = 120
Sales = (365/Collection period) Average receivables
= (365/71.2) [(44 + 34)/2] = 199.93
EBIT = 199.93 120 10 20 = 49.93
EBIT tax = ROA (Average total assets) = 0.18 (115 + 105)/2 = 19.8
Tax = 49.93 19.8 = 30.13
LT Debt + equity = 115 Current liabilities = 115 55 = 60
LT debt = LT debt ratio 60 = 0.4 60 = 24
Shareholders equity = 60 24 = 36
Net income = ROE Average equity = 0.41 [(36+30)/2] = 13.53
Income before tax = 30.13 + 13.53 = 43.66
Interest expense = EBIT Income before taxes = 49.93 43.66 = 6.27

17-9

Solution to Minicase for Chapter 17

You will find an Excel spreadsheet solution to this minicase at the Online Learning Center
(www.mhhe.com/bmm4e).

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