financial ratios

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CHAPTER 15 FINANCIAL STATEMENT ANALYSIS

CLASS DISCUSSION QUESTIONS

1. Horizontal analysis is the percentage analy-sis of increases and decreases in corre-sponding statements. The percent change in the cash balances at the end of the preced-ing year from the end of the current year is an example. Vertical analysis is the percent-age analysis showing the relationship of the component parts to the total in a single statement. The percent of cash as a portion of total assets at the end of the current year is an example.

2. Comparative statements provide information as to changes between dates or periods. Trends indicated by comparisons may be far more significant than the data for a single date or period.

3. Before this question can be answered, the increase in net income should be compared with changes in sales, expenses, and assets devoted to the business for the current year. The return on assets for both periods should also be compared. If these comparisons in-dicate favorable trends, the operating per-formance has improved; if not, the apparent favorable increase in net income may be off-set by unfavorable trends in other areas.

4. You should first determine if the expense amount in the base year (denominator) is significant. A 100% or more increase of a very small expense item may be of little con-cern. However, if the expense amount in the base year is significant, then over a 100% increase may require further investigation.

5. Generally, the two ratios would be very close, because most service businesses sell services and hold very little inventory.

6. The amount of working capital and the change in working capital are just two indica-tors of the strength of the current position. A comparison of the current ratio and the quick ratio, along with the amount of working capi-tal, gives a better analysis of the current po-sition. Such a comparison shows:

Current Preceding Year Year Working capital....... $42,500 $37,500 Current ratio............ 2.0 2.5 Quick ratio .............. 0.8 1.2

It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.2 to 0.8.

7. The bulk of Wal-Mart sales are to final cus-tomers that pay with credit cards or cash. In either case, there is no accounts receivable. Procter and Gamble, in contrast, sells al-most exclusively to other businesses, such as Wal-Mart. Such sales are “on account,” and thus, create accounts receivable that must be collected. A recent financial state-ment showed Wal-Mart’s accounts receiv-able turning 109 times, while Procter and Gamble’s turned only 13 times.

8. No, an accounts receivable turnover of 6 with sales on a n/30 basis is not satisfactory. It indicates that accounts receivable are col-lected, on the average, in one-sixth of a year, or approximately 60 days from the date of sale. Assuming that some customers pay within the 30-day term, it indicates that other accounts are running beyond 60 days. It is also possible that there is a substantial amount of past-due accounts of doubtful col-lectibility on the books.

9. a. A high inventory turnover minimizes the amount invested in inventories, thus freeing funds for more advantageous use. Storage costs, administrative ex-penses, and losses caused by obsoles-cence and adverse changes in prices are also kept to a minimum.

b. Yes. The inventory turnover could be high because the quantity of inventory on hand is very low. This condition might result in the lack of sufficient goods on hand to meet sales orders.

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c. Yes. The inventory turnover relates to the “turnover” of inventory during the year, while the number of days’ sales in inventory relates to the amount of inven-tory on hand at the end of the year. Therefore, a business could have a high inventory turnover for the year, yet have a high number of days’ sales in inventory at the end of the year.

10. The ratio of fixed assets to long-term liabili-ties increased from 2 for the preceding year to 2.5 for the current year, indicating that the company is in a stronger position now than in the preceding year to borrow additional funds on a long-term basis.

11. a. Due to leverage, the rate on stockhold-ers’ equity will often be greater than the rate on total assets. This occurs be-cause the amount earned on assets ac-quired through the use of funds provided by creditors exceeds the interest charges paid to creditors.

b. Higher. The concept of leverage applies to preferred stock as well as debt. The rate earned on common stockholders’ equity ordinarily exceeds the rate earned on total

stockholders’ equity because the amount earned on assets acquired through the use of funds provided by preferred stockhold-ers normally exceeds the dividends paid to preferred stockholders.

12. The earnings per share in the preceding year were $20 per share ($40/2), adjusted for the stock split in the latest year.

13. A share of common stock is currently selling at 10 times current annual earnings.

14. The dividend yield on common stock is a measure of the rate of return to common stockholders in terms of cash dividend dis-tributions. Companies in growth industries typically reinvest a significant portion of the amount earned in common stockholders’ equity to expand operations rather than to return earnings to stockholders in the form of cash dividends.

15. During periods when sales are increasing, it is likely that a company will increase its in-ventories and expand its plant. Such situa-tions frequently result in an increase in cur-rent liabilities out of proportion to the in-crease in current assets and thus lower the current ratio.

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EXERCISES

Ex. 15–1

a. HOME-MATE APPLIANCE CO.

Comparative Income Statement For the Years Ended December 31, 2006 and 2005

2006 2005 Amount Percent Amount Percent

Sales............................................ $500,000 100.0% $450,000 100.0% Cost of goods sold..................... 275,000 55.0 234,000 52.0 Gross profit................................. $225,000 45.0% $216,000 48.0% Selling expenses ........................ $ 90,000 18.0% $ 94,500 21.0% Administrative expenses ........... 60,000 12.0 63,000 14.0 Total operating expenses.......... $150,000 30.0% $157,500 35.0% Income from operations ............ $ 75,000 15.0% $ 58,500 13.0% Income tax expense ................... 25,000 5.0 22,500 5.0 Net income.................................. $ 50,000 10.0% $ 36,000 8.0% b. The vertical analysis indicates that the cost of goods sold as a percent of

sales increased by 3 percentage points (55% – 52%) between 2005 and 2006. However, the selling expenses and administrative expenses improved by 5 percentage points. Thus, the net income as a percent of sales improved by 2 percentage points.

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Ex. 15–2

a. Speedway Motorsports, Inc.

Comparative Income Statement (in thousands of dollars) For the Years Ended December 31, 2002 and 2001

2002 2001

Revenues: Admissions...................................... $141,315 37.6% $136,362 36.3% Event-related revenue .................... 122,172 32.5 133,289 35.5 NASCAR broadcasting revenue..... 77,936 20.7 67,488 18.0 Other operating revenue ................ 34,537 9.2 38,111 10.2 Total revenues ........................... $375,960 100.0% $375,250 100.0% Expenses and other: Direct expense of events................ $ 69,297 18.4% $ 76,579 20.4% NASCAR purse and sanction fees. 61,217 16.3 54,479 14.5 Other direct expenses .................... 87,427 23.3 88,582 23.6 General and administrative............ 57,235 15.2 59,331 15.8 Total expenses and other ......... $275,176 73.2% $278,971 74.3% Income from continuing operations ... $100,784 26.8% $ 96,279 25.7% b. While overall revenue did not change much between the two years, the over-

all mix of revenue sources did change somewhat. The event-related revenues (such as concessions) declined as a percent of total revenues by three per-centage points, while the percent of NASCAR broadcasting revenues to total revenues increased by nearly three (2.7) percentage points. The expenses as a percent of total revenues shifted the most between the direct event ex-penses and NASCAR purse and sanction fees. That is, the direct expenses as a percent of total revenues declined nearly two percentage points, while the NASCAR purse and sanction fees as a percent of total revenues increased by nearly two (1.8) percentage points. Overall, the income from continuing op-erations increased a modest 1.1 percentage points of total revenues between the two years, which is a favorable trend. As a further note, the income from continuing operations as a percent of sales exceeds 25% in both years, which is excellent. Apparently, owning and operating motor speedways is a busi-ness that produces high operating profit margins.

Note to Instructors: The high operating margin is probably necessary to com-

pensate for the extensive investment in speedway assets. This is confirmed by the rate of operating income return on total assets of nearly 9%.

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Ex. 15–3

a. HORIZON PUBLISHING COMPANY Common-Size Income Statement

For the Year Ended December 31, 20—

Horizon Publishing Publishing Industry Company Average Amount Percent

Sales................................................................. $ 1,414,000 101.0% 101.0% Sales returns and allowances........................ 14,000 1.0 1.0 Net sales .......................................................... $ 1,400,000 100.0% 100.0% Cost of goods sold.......................................... 504,000 36.0 40.0 Gross profit...................................................... $ 896,000 64.0% 60.0% Selling expenses ............................................. $ 574,000 41.0% 39.0% Administrative expenses ................................ 154,000 11.0 10.5 Total operating expenses............................... $ 728,000 52.0% 49.5% Operating income............................................ $ 168,000 12.0% 10.5% Other income ................................................... 16,800 1.2 1.2 $ 184,800 13.2% 11.7% Other expense ................................................. 23,800 1.7 1.7 Income before income tax.............................. $ 161,000 11.5% 10.0% Income tax expense ........................................ 56,000 4.0 4.0 Net income....................................................... $ 105,000 7.5% 6.0%

b. The cost of goods sold is 4 percentage points lower than the industry aver-

age, but the selling expenses and administrative expenses are 2.5 percentage points higher than the industry average. The combined impact is for net in-come as a percent of sales to be 1.5 percentage points better than the indus-try average. Apparently, the company is managing the cost of publishing books better than the industry but has slightly higher selling and administra-tive expenses relative to the industry. The cause of the higher selling and administrative expenses as a percent of sales, relative to the industry, can be investigated further.

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Ex. 15–4

SANTA FE TILE COMPANY Comparative Balance Sheet December 31, 2006 and 2005


Current assets .............................. $260,000 32.50% $200,000 28.57% Property, plant, and equipment... 500,000 62.50 450,000 64.29 Intangible assets .......................... 40,000 5.00 50,000 7.14 Total assets .................................. $800,000 100.00% $700,000 100.00%

Current liabilities.......................... $170,000 21.25% $150,000 21.43% Long-term liabilities ..................... 210,000 26.25 200,000 28.57 Common stock ............................. 50,000 6.25 50,000 7.14 Retained earnings ........................ 370,000 46.25 300,000 42.86 Total liabilities and stockholders’ equity ............... $800,000 100.00% $700,000 100.00%

Ex. 15–5

a. SCRIBE PAPER COMPANY Comparative Income Statement

For the Years Ended December 31, 2006 and 2005

2006 2005 Increase (Decrease) Amount Amount Amount Percent

Sales............................................ $ 66,300 $ 85,000 $ (18,700) – 22.00% Cost of goods sold..................... 32,000 40,000 (8,000) – 20.00% Gross profit................................. $ 34,300 $ 45,000 $ (10,700) – 23.78% Selling expenses ........................ $ 24,000 $ 25,000 $ (1,000) – 4.00% Administrative expenses ........... 7,500 6,000 1,500 25.00% Total operating expenses.......... $ 31,500 $ 31,000 $ 500 1.61% Income before income tax......... $ 2,800 $ 14,000 $ (11,200) – 80.00% Income tax expense ................... 1,000 6,000 (5,000) – 83.33% Net income.................................. $ 1,800 $ 8,000 $ (6,200) – 77.50%

b. The net income for Scribe Paper Company decreased by approximately 77.5% from 2005 to 2006. This decrease was the combined result of a decrease in sales of 22% and higher expenses. The cost of goods sold decreased at a slower rate than the decrease in sales, thus causing gross profit to decrease more than the decrease in sales. In addition, selling and administrative ex-penses increased by 1.61% between 2005 and 2006.

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Ex. 15–6

a. (1) Working capital = Current assets – Current liabilities 2006: $875,000 – $250,000 = $625,000 2005: $795,000 – $265,000 = $530,000

(2) Current ratio = Current assets

Current liabilities

2006: $250,000$875,000

= 3.5 2005: $265,000$795,000

= 3.0

(3) Quick ratio = Quick assetsCurrent liabilities

2006: $250,000$480,000

= 1.92 2005: $265,000$424,000

= 1.6

b. The liquidity of Marine Equipment has improved from the preceding year to the current year. The working capital, current ratio, and quick ratio have all increased. Most of these changes are the result of a decrease in current li-abilities, specifically accounts (notes) payable, combined with an increase in the current assets.

Ex. 15–7

a. (1) Current ratio = Current assets

Current liabilities

Dec. 28, 2002: 052,6$413,6$

= 1.06 Dec. 28, 2001: 998,4$853,5$

= 1.17

(2) Quick ratio = Quick assetsCurrent liabilities

Dec. 28, 2002: 052,6$376,4$

= 0.72 Dec. 28, 2001: 998,4$791,3$

= 0.76

b. The liquidity of PepsiCo has declined significantly over this time period. Both

the current and quick ratios have declined. The current ratio declined from 1.17 to 1.06, and the quick ratio declined from 0.76 to 0.72. Neither of these declines is worrisome, however. PepsiCo is a strong company with ample re-sources for meeting short-term obligations.

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Ex. 15–8

a. The working capital, current ratio, and quick ratio are calculated incorrectly. The working capital and current ratio incorrectly include Goodwill as a part of current assets. Goodwill is an intangible asset and is noncurrent. The quick ratio has the correct numerator (quick assets) but does not include accrued liabilities in the denominator. The denominator of the quick ratio should be total current liabilities.

The correct calculations are as follows: Working capital = Current assets – Current liabilities $900,000 – $625,000 = $275,000

Current ratio = Current assetsCurrent liabilities

$625,000$900,000

= 1.44

Quick ratio = Quick assetsCurrent liabilities

$625,000

$172,000 + $123,000 + $275,000 = 0.912

b. Unfortunately, the working capital, current ratio, and quick ratio are all below

the minimum threshold required by the bond indenture. This may require the company to renegotiate the bond contract, including a possible unfavorable change in the interest rate.

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Ex. 15–9

a. (1) Accounts receivable turnover: receivable accounts monthly Average

account on salesNet

Current year: $45,070

$320,000 = 7.1 Preceding year:

$46,154$300,000

= 6.5

(2) Number of days' sales in receivables: Accounts receivable, end of yearAverage daily sales on account

Current year: 1$877$48,219

= 55.0 days

Preceding year: 2$822$52,603

= 64.0 days

1$877 = $320,000 ÷ 365 days

2$822 = $300,000 ÷ 365 days

b. The collection of accounts receivable has improved. This can be seen in both

the increase in accounts receivable turnover and the reduction in the collec-tion period. The credit terms require payment in 60 days. In the previous pe-riod, the collection period exceeded these terms. However, the company ap-parently became more aggressive in collecting accounts receivable or more restrictive in granting credit to customers. Thus, in the current period the col-lection period is within the credit terms of the company.

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Ex. 15–10

a. (1) Accounts receivable turnover: receivable accounts Average

account on salesNet

Sears: 2/)759,30$+155,28($

698,35$ = 1.2

Federated: 2/)945,2$+379,2($

434,15$ = 5.8

(2) Number of days’ sales in receivables: account on sales daily Average

yearof end ,receivable Accounts

Sears: 18.97$759,30$

= 314.5 days

Federated: 23.42$945,2$

= 69.6 days

1$97.8 = $35,698 ÷ 365 days 2$42.3 = $15,434 ÷ 365 days b. Sears’ accounts receivable turnover is much less than Federated’s (1.2 for

Sears vs. 5.8 for Federated). Likewise, the number of days’ sales in receiv-ables is much greater for Sears than for Federated (314.4 days for Sears vs. 69.6 days for Federated). These differences must be interpreted with care. Sears has significant MasterCard receivables with customers who have not made purchases from Sears, which represent receivables that do no corre-spond to Sears’ sales. Thus, it is not surprising that Sears has a much lower turnover than does Federated, since the accounts receivable include receiv-ables that are outside of the Sears retail network. In addition, we do not know how much of the Sears or Federated sales are on credit; thus, it is not possi-ble to accurately compare the number of days’ sales in receivables with credit terms.

Note to Instructors: The annual 10-K for Federated indicated that the sales through its proprietary credit card was $4,128. Thus, the accounts receivable turnover based on this number would be 1.6 ($4,128 ÷ $2,662), while the number of days’ sales in receivables would be 260.6 days ($2,945 ÷ $11.3). Thus, the calculations in part a. above actually overstate Federated’s ac-counts receivable turnover and understates Federated’s credit card days’ sales in receivables. This exercise helps the student see the importance of in-terpreting these ratios carefully. In the case of Sears, much of the receivables are not related to Sears’ sales, which distorts the ratio. In the case of Feder-ated, only $4,128 million in sales were on account, thus actually overstating its accounts receivable turnover and understating its days’ sales in receiv-able, relative to the sales on account.

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Ex. 15–11

a. (1) Inventory turnover: Cost of goods soldAverage inventory

2006: (((( )))) 2/$40,000 + $42,000$328,000

= 8.0

2005: (((( )))) 2/$42,000 + $44,000$430,000

= 10.0

(2) Number of days' sales in inventory: Inventory, end of yearAverage daily cost of goods sold

2006: 1$899$40,000

= 44.49 days

2005: 2$1,178$42,000

= 35.65 days

1$899 = $328,000 ÷ 365 days

2$1,178 = $430,000 ÷ 365 days

b. The inventory position of the business has deteriorated. The inventory turn-

over has decreased, while the number of days’ sales in inventory has in-creased. The sales volume has declined faster than the inventory has de-clined, thus resulting in the deteriorating inventory position.

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Ex. 15–12

a. (1) Inventory turnover: Cost of goods soldAverage inventory

Dell: (((( )))) 2/$306 + $278$29,055

= 99.5

HP: (((( )))) 2/797,$5 + $5,204$34,573

= 13.4

(2) Number of days' sales in inventory: Inventory, end of yearAverage daily cost of goods sold

Dell: 16.79$306$

= 3.8 days

Hewlett Packard: 2$94.7$5,797

= 61.2 days

1$79.6 = $29,055 ÷ 365 days

2$94.7 = $34,573 ÷ 365 days

b. Dell has a much higher inventory turnover ratio than does HP (99.5 vs. 6.3 for

HP). Likewise, Dell has a much smaller number of days’ sales in inventory (3.8 days vs. 61.2 days for HP). These significant differences are a result of Dell’s make-to-order strategy. Dell has successfully developed a manufactur-ing process that is able to fill a customer order quickly. As a result, Dell does not need to prebuild computers to inventory. HP, in contrast, prebuilds com-puters, printers, and other equipment to be sold by retail stores and other re-tail channels. In this industry, there is great obsolescence risk in holding computers in inventory. New technology can make an inventory of computers difficult to sell; therefore, inventory is costly and risky. Dell’s operating strat-egy is considered revolutionary and is now being adopted by many both in and out of the computer industry. Indeed, at the time of this writing, HP and Gateway are changing their practices to mirror those of Dell. Apple Computer also employs similar manufacturing techniques, and thus enjoys excellent in-ventory efficiency.

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Ex. 15–13

a. Ratio of liabilities to stockholders’ equity: Total liabilitiesTotal stockholders' equity

Dec. 31, 2006: $2,500,000$1,350,000

= 0.54 Dec. 31, 2005: $2,200,000$1,540,000

= 0.70

b.

Number of times bondinterest charges were earned:

expenseInterest expenseInterest + tax before Income

Dec. 31, 2006: $96,000

*000,$96 $528,000 ++++ = 6.50

Dec. 31, 2005: $112,000

**$112,000 $336,000 ++++ = 4.0

*$1,200,000 × 8% = $96,000 **$1,400,000 × 8% = $112,000 c. Both the ratio of liabilities to stockholders’ equity and the number of times

bond interest charges were earned have improved significantly from 2005 to 2006. These results are the combined result of a larger income before taxes and lower serial bonds payable in the year 2006 compared to 2005.

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Ex. 15–14

a. Ratio of liabilities to stockholders’ equity: Total liabilities

Total stockholders' equity

Hasbro Inc.: $2,016,115,000$1,352,864,000

= 1.49

Mattel Inc.: $2,802,103,000$1,738,458,000

= 1.61

b.

:earned werechargesinterest

times of Number

expenseInterest expenseInterest tax beforeInterest ++++

Hasbro Inc.: 00$103,688,0

00$103,688,0 0$96,199,00 ++++ = 1.93

Mattel Inc.: 00$155,132,0

00$155,132,0 00$430,010,0 ++++ = 3.77

c. Both companies carry a moderate proportion of debt to the stockholders’ eq-

uity, at nearly 1.5 times stockholders’ equity. Mattel has slightly more debt as a percent of stockholders’ equity than does Hasbro (1.61 vs. 1.49). However, Mattel has much better interest coverage than does Hasbro. The reason is because Mattel has earned much more than Hasbro in relation to interest charges. That is, even though Mattel uses more debt and has higher interest charges than does Hasbro, Mattel’s earnings more than offset these differ-ences. As a result, Hasbro has only a 1.93 coverage ratio, while Mattel has 3.77 number of time interest charges are earned. Overall, Mattel has a higher debt than does Hasbro, but has the earnings to support the interest charges of the debt. Hasbro’s debt is somewhat lower as a percent of stockholders’ equity, but has lower earnings, causing a weaker (although adequate) interest coverage.

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Ex. 15–15

a. Ratio of liabilities to stockholders’ equity: Total liabilities

Total stockholders' equity

H.J. Heinz: $2,509,169 + $4,642,968 + $1,407,607

$1,718,616 = 4.98

Hershey Foods: $606,444 + $876,972 + $1,223,254

$1,147,204= 2.36

b. Ratio of fixed assets to long-term liabilities: Fixed assets (net)

Long-term liabilities

H.J. Heinz: $2,250,074$4,642,968

= 0.48

Hershey Foods: $1,534,901$876,972

= 1.75

c. H.J. Heinz uses much more debt than does Hershey Foods. This is evident in

both ratios. The total liabilities to stockholders’ equity ratio shows debt at 4.98 times the stockholders’ equity for H.J. Heinz, compared to only 2.36 times stockholders’ equity for Hershey Foods. H.J. Heinz’s ratio of total liabili-ties to stockholders’ equity is very high, and would indicate little additional capacity for debt. The ratio of fixed assets to long-term liabilities suggests the same relationship. This ratio divides the property, plant, and equipment (net) by the long-term debt. The denominator should not include the other long-term liabilities such as pensions and deferred tax credits because these items are not related to financing fixed assets. The ratio for H.J. Heinz is, again, aggressive with only 48% of fixed assets covering the long-term debt. That is, the creditors of H.J. Heinz have less than 50 cents of property, plant, and equipment covering every dollar of long-term debt. The same ratio for Hershey Foods shows fixed assets covering 1.75 times the long-term debt. That is, the creditors of Hershey Foods have $1.75 of property, plant, and equipment covering every dollar of long-term debt. This would suggest that Hershey has stronger creditor protection and borrowing capacity than does H.J. Heinz.

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Ex. 15–16

a. Ratio of net sales to total assets: Net sales

Total assets

Yellow Corp.: $3,276,651$1,285,777

= 2.55

Union Pacific: $11,973,000$31,551,000

= 0.38

C.H. Robinson Worldwide: $3,090,072$683,490

= 4.52

b. The ratio of net sales to assets measures the number of sales dollars earned

for each dollar of assets. The greater the number of sales dollars earned for every dollar of assets, the more efficient a firm is in using assets. Thus, the ratio is a measure of the efficiency in using assets. The three companies are different in their efficiency in using assets, because they are different in the nature of their operations. Union Pacific earns only 38 cents for every dollar of assets. This is because Union Pacific is very asset intensive. That is, Union Pacific must invest in locomotives, railcars, terminals, tracks, right-of-way, and information systems in order to earn revenues. These investments are significant. Yellow Corp. is able to earn $2.55 for every dollar of assets, and thus, is able to earn more revenue for every dollar of assets than the railroad. This is because the motor carrier invests in trucks, trailers, and terminals, which require less investment per dollar of revenue than does the railroad. Moreover, the motor carrier does not invest in the highway system, because the government owns the highway system. Thus, the motor carrier has no in-vestment in the transportation network itself unlike the railroad. The transpor-tation arranger hires transportation services from motor carriers and rail-roads, but does not own these assets itself. The transportation arranger has assets in accounts receivable and information systems but does not require transportation assets; thus, it is able to earn the highest revenue per dollar of assets.

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Ex. 15–16 Concluded

Note to Instructors: Students may wonder how asset intensive companies overcome their asset efficiency disadvantages to competitors with better as-set efficiencies, as in the case between railroads and motor carriers. Asset ef-ficiency is part of the financial equation; the other part is the profit margin made on each dollar of sales. Thus, companies with high asset efficiency of-ten operate on thinner margins than do companies with lower asset effi-ciency. For example, the motor carrier must pay highway taxes, which lowers its operating margins when compared to railroads that own their right-of-way, and thus do not have the tax expense of the highway. In this exercise the rail-road has the highest profit margins, the motor carrier is in the middle, while the transportation arranger operates on very thin margins.

Ex. 15–17

a. Rate earned on total assets: Net income plus interestAverage total assets

2007: *$1,375,000

000,15$ + $150,000 = 12.0% 2006:

**$1,200,000000,15$ + $180,000

= 16.25%

*($1,300,000 + $1,450,000) ÷ 2 **($1,100,000 + $1,300,000) ÷ 2

Rate earned on stockholders’ equity: Net incomeAverage stockholders' equity

2007: *$1,080,000

$150,000 = 13.89% 2006:

**$935,000$180,000

= 19.25%

*($1,015,000 + $1,145,000) ÷ 2 **($855,000 + $1,015,000) ÷ 2

Rate earned oncommon stockholders' equity:

Net income less preferred dividendsAverage common stockholders' equity

2007: *$880,000

$20,000 $150,000 −−−− = 14.77% 2006: **$735,000

$20,000 $180,000 −−−− = 21.77%

*($815,000 + $945,000) ÷ 2 **($655,000 + $815,000) ÷ 2 b. The profitability ratios indicate that Yellowstone’s profitability has deterio-

rated. Most of this change is from net income falling from $180,000 in 2006 to $150,000 in 2007. The cost of debt is 8%. Since the rate of return on assets exceeds this amount in either year, there is positive leverage from use of debt. However, this leverage is greater in 2006 because the rate of return on assets exceeds the cost of debt by a greater amount in 2006.

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Ex. 15–18

a. Rate earned on total assets: assets total Average

expenseinterest incomeNet ++++

2002: )/2$1,010,826 + ($883,166

$6,886 + $80,158 = 9.2% 2001:

2$848,115)/ + ($883,166869,$6 + $29,105

= 4.2%

b. Rate earned on stockholders’ equity: equity rs'stockholde Average

incomeNet

2002: )/2$1,010,826 + ($883,166

$80,158 = 12.1% 2001:

2$848,115)/ + ($883,166 $29,105

= 4.9%

c. Both the rate earned on total assets and the rate earned on stockholders’ eq-uity have improved over the two-year period. The rate earned on total assets improved from 4.2% to 9.2%, which is over twice the return of the prior year. However, the rate earned on stockholders’ equity improved from 3.13% to 9.63%, which was over a three-fold improvement. The rate earned on stock-holders’ equity improved from 4.9% to 12.1%. The rate earned on stockhold-ers’ equity exceeds the rate earned on total assets due to the positive use of leverage.

d. Fiscal year 2002 was a difficult time for the apparel industry. The rate earned on total assets for Ann Taylor, however, exceeded the industry average (9.2% vs. 6%). The rate earned on stockholders’ equity was also greater than the in-dustry average (12.1% vs. 7.8%). These relationships suggest that Ann Taylor has more leverage than the industry, on average.

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Ex. 15–19

a. Ratio of fixed assets to long-term liabilities: Fixed assets

Long-term liabilities

$680,000$950,000

= 1.40

b. Ratio of liabilities to stockholders’ equity: Total liabilitiesTotal stockholders' equity

$1,466,000$725,000

= 0.49

c. Ratio of net sales to assets: Net sales

Average total assets (excluding investments)

*$1,900,000

$3,000,000 = 1.58

*[($2,009,000 + $2,191,000) ÷ 2] – $200,000. The end-of-period total assets are equal to the sum of total liabilities ($725,000) and stockholders’ equity ($1,466,000).

d. Rate earned on total assets: Net income plus interestAverage total assets

*$2,100,000

$51,000 + $180,000 = 11.00%

*($2,009,000 + $2,191,000) ÷ 2

e. Rate earned on stockholders’ equity: Net incomeAverage stockholders' equity

*$1,408,000

$180,000 = 12.78%

*[($200,000 + $650,000 + $500,000) + $1,466,000] ÷ 2

f.

Rate earned oncommon stockholders' equity:

Net income less preferred dividendsAverage common stockholders' equity

*$1,208,000

$16,000 $180,000 −−−− = 13.58%

* [($650,000 + $500,000) + ($650,000 + $616,000)] ÷ 2

680

Ex. 15–20

a.

Number of times bondinterest charges were earned:

Income before tax + Interest expenseInterest expense

$180,000

$180,000 + $450,000 = 3.5 times

b. Number of times preferred dividends were earned: Net income

Preferred dividends

$25,000

$325,000 = 13 times

c. Earnings per share on common stock: Net income Preferred dividends

Common shares outstanding−−−−

shares 125,000$25,000 $325,000 −−−− = $2.40

d. Price-earnings ratio: share per Earnings

share per priceMarket

$2.40$50

= 20.83

e. Dividends per share of common stock: Common dividends

Common shares outstanding

shares 125,000

$100,000 = $0.80

f. Dividend yield: Common dividend per share

Share price

$50.00$0.80

= 1.6%

681

Ex. 15–21

a. Earnings per share: Net income Preferred dividends


shares 200,000$54,000 $444,000 −−−− = $1.95

b. Price-earnings ratio: share per Earnings

share per priceMarket

$1.95$39.00

= 20

c. Dividends per share: Common dividends

Common shares outstanding

shares 200,000

$156,000 = $0.78

d. Dividend yield: Common dividend per shareShare price

$39.00$0.78

= 2.0%

Ex. 15–22

a. Earnings per share on income before extraordinary items:

Net income ..................................................................... $ 890,000 Less gain on condemnation ......................................... (256,000) Plus loss from flood damage........................................ 166,000 Income before extraordinary items.............................. $ 800,000

Earnings before extraordinary items per share on common stock:

Income before extraordinary items Preferred dividends


shares 500,000$320,000 $800,000 −−−− = $0.96 per share

b. Earnings per share on common stock: Net income Preferred dividends


shares 500,000$320,000 $890,000 −−−− = $1.14 per share

682

Ex. 15–23

a. Price-earnings ratio: Market price per share

Earnings per share

Bank of America: $68.20$5.91

= 11.54

eBay: $73.56$0.85

= 86.54

Coca-Cola: $40.06$1.68

= 23.85

Dividend yield: Dividend per share

Market price per share

Bank of America: $2.56

$68.20= 3.75%

eBay: $0

$73.56= 0

Coca-Cola: $0.80

$40.06= 2.0%

b. Bank of America has the largest dividend yield, but the smallest price-

earnings ratio. Stock market participants value Bank of America common stock on the basis of its dividend. The dividend is an attractive yield at this date. Because of this attractive yield, stock market participants do not expect the share price to grow significantly, hence the low price-earnings valuation. This is a typical pattern for companies that pay high dividends. eBay shows the opposite extreme. eBay pays no dividend, and thus has no dividend yield. However, eBay has the largest price-earnings ratio of the three companies. Stock market participants are expecting a return on their investment from ap-preciation in the stock price. Some would say that the stock is priced very aggressively at 86.54 times earnings. Coca-Cola is priced in between the other two companies. Coca-Cola has a moderate dividend producing a yield of 2%. The price-earnings ratio is near 24, which is close to the market aver-age at this writing. Thus, Coca-Cola is expected to produce shareholder re-turns through a combination of some share price appreciation and a small dividend.

683

PROBLEMS

Prob. 15–1A

1. TURNBERRY COMPANY


Increase (Decrease) 2006 2005 Amount Percent

Sales.............................................. $482,000 $429,000 $ 53,000 12.35% Sales returns and allowances..... 6,000 4,000 2,000 50.00% Net sales ....................................... $476,000 $425,000 $ 51,000 12.00% Cost of goods sold....................... 216,000 180,000 36,000 20.00% Gross profit................................... $260,000 $245,000 $ 15,000 6.12% Selling expenses .......................... $109,250 $ 95,000 $ 14,250 15.00% Administrative expenses ............. 52,500 30,000 22,500 75.00% Total operating expenses............ $161,750 $125,000 $ 36,750 29.40% Income from operations .............. $ 98,250 $120,000 $ (21,750) (18.13)% Other income ................................ 2,000 2,000 0 0.00% Income before income tax........... $100,250 $122,000 $ (21,750) (17.83)% Income tax expense ..................... 30,000 40,000 (10,000) (25.00)% Net income.................................... $ 70,250 $ 82,000 $ (11,750) (14.33)% 2. Net income has declined from 2005 to 2006. Net sales have increased by 12%;

however, cost of goods sold has increased by 20%, causing the gross profit to grow at a rate less than sales relative to the base year. In addition, total operating expenses have increased over twice as fast as sales (29.4% in-crease vs. 12% net sales increase). Increases in costs and expenses that are higher than the increase in sales have caused the net income to decline by approximately 14%.

684

Prob. 15–2A

1. AUDIO TONE COMPANY



Sales............................................ $ 664,000 100.61% $ 526,000 101.15% Sales returns and allowances... 4,000 0.61 6,000 1.15 Net sales ..................................... $ 660,000 100.00% $ 520,000 100.00% Cost of goods sold..................... 257,400 39.00 213,200 41.00 Gross profit................................. $ 402,600 61.00% $ 306,800 59.00% Selling expenses ........................ $ 138,600 21.00% $ 124,800 24.00% Administrative expenses ........... 72,600 11.00 67,600 13.00 Total operating expenses.......... $ 211,200 32.00% $ 192,400 37.00% Income from operations ............ $ 191,400 29.00% $ 114,400 22.00% Other income .............................. 2,500 0.38 2,000 0.38 Income before income tax......... $ 193,900 29.38% $ 116,400 22.38% Income tax expense ................... 54,000 8.18 30,000 5.77 Net income.................................. $ 139,900 21.20% $ 86,400 16.61%*

*Rounded to next lowest hundredth of a percent 2. The vertical analysis indicates that the costs (cost of goods sold, selling ex-

penses, and administrative expenses) as a percent of sales improved from 2005 to 2006. As a result, net income as a percent of sales increased from 16.61% to 21.20%. The sales promotion campaign appears successful. The selling expenses as a percent of sales declined, suggesting that the in-creased cost was more than made up by increased sales.

685

Prob. 15–3A

1. a. Working capital = Current assets – Current liabilities $1,255,000 – $590,000 = $665,000

b. Current ratio = Current assetsCurrent liabilities

$590,000

$1,255,000 = 2.13

c. Quick ratio = Quick assetsCurrent liabilities

$590,000

$380,000 + $110,000 + $240,000 = 1.24

2. Supporting Calculations Working Current Quick Current Quick Current Transaction Capital Ratio Ratio Assets Assets Liabilities

a. $665,000 2.13 1.24 $1,255,000 $730,000 $590,000 b. 665,000 2.25 1.26 1,195,000 670,000 530,000 c. 665,000 1.99 1.09 1,335,000 730,000 670,000 d. 665,000 2.21 1.25 1,215,000 690,000 550,000 e. 640,000 2.04 1.19 1,255,000 730,000 615,000 f. 665,000 2.13 1.24 1,255,000 730,000 590,000 g. 785,000 2.33 1.44 1,375,000 850,000 590,000 h. 665,000 2.13 1.24 1,255,000 730,000 590,000 i. 915,000 2.55 1.66 1,505,000 980,000 590,000 j. 665,000 2.13 1.22 1,255,000 720,000 590,000

686

Prob. 15–4A

1. Working capital: $871,000 – $290,000 = $581,000

Calculated Ratio Numerator Denominator Value

2. Current ratio .................. $871,000 $290,000 3.0 3. Quick ratio ..................... $762,000 $290,000 2.6 4. Accounts receivable turnover ......................... $1,050,000 ($165,000 + $199,000)/2 5.8 5. Number of days' sales in receivables....... $199,000 ($1,050,000/365) 69.2 6. Inventory turnover......... $400,000 ($84,000 + $52,000)/2 5.9 7. Number of days' sales in inventory.......... $84,000 ($400,000/365) 76.7 8. Fixed assets to long- term liabilities................ $1,040,000 $900,000 1.2 9. Liabilities to stockholders' equity............... $1,190,000 $1,021,000 1.2 10. Number of times interest charges earned ............................ $109,000 + $96,000 $96,000 2.1 11. Number of times preferred dividends earned ............................ $68,000 $15,000 4.5 12. Ratio of net sales to assets............................. $1,050,000 ($1,911,000 + $1,375,000)/2 0.6 13. Rate earned on total assets............................. $68,000 + $96,000 ($2,211,000 + $1,575,000)/2 8.7% 14. Rate earned on stockholders' equity............... $68,000 ($1,021,000 + $925,000)/2 7.0% 15. Rate earned on common stockholders' equity............... ($68,000 – $15,000) ($771,000 + $725,000)/2 7.1% 16. Earnings per share on common stock.......... ($68,000 – $15,000) 35,000 $1.51 17. Price-earnings ratio....... $20.00 $1.51 13.2 18. Dividends per share of common stock .......... $7,000 35,000 $0.20 19. Dividend yield................ $0.20 $20.00 1.0%

687

Prob. 15–5A

1. a.

0 .00

0 .05

0 .10

0 .15

0 .20

0 .25

0 .30

2006 2005 2004 2003 2002

Year

Rat

e ea

rned

on

tota

l ass

ets

Industry rateearned on to talassets

S age rate earnedon to tal assets

Rate earned on total assets: assets total Average

expenseInterest incomeNet ++++

2006: $5,250,000$1,400,000

= 0.27 2003: $2,300,000$520,000

= 0.23

2005: $4,000,000$970,000

= 0.24 2002: $1,800,000$400,000

= 0.22

2004: $3,050,000$750,000

= 0.25

688

Prob. 15–5A Continued

1. b.

0 .00

0 .05

0 .10

0 .15

0 .20

0 .25

0 .30

0 .35

0 .40

2006 2005 2004 2003 2002

Year

Rat

e ea

rned

on

stoc

khol

ders

' equ

ity

Industry rateearned onstockholders'equ ity

S age rate earnedon stockho lders'equ ity

Rate earned on stockholders’ equity: equity rs'stockholde Average

incomeNet

2006: $3,400,000$1,200,000

= 0.35 2003: $1,200,000$400,000

= 0.33

2005: $2,400,000$800,000

= 0.33 2002: $900,000$300,000

= 0.33

2004: $1,700,000$600,000

= 0.35

689


1. c.

0 .000

1 .000

2 .000

3 .000

4 .000

5 .000

6 .000

7 .000

8 .000

9 .000

10 .000

2006 2005 2004 2003 2002

Y ear

Num

ber

of ti

mes

inte

rest

cha

rges

ear

ned

Industry num ber o ftim es in terestcharges are earned

S age num ber o ftim es in terestcharges are earned

earned werechargesinterest

times of Number =

expenseInterest expenseInterest expense tax Income incomeNet ++++++++

2006: $200,000

$1,760,000 = 8.80 2003:

$120,000$640,000

= 5.33

2005: $170,000

$1,210,000 = 7.12 2002:

$100,000$490,000

= 4.90

2004: $150,000$930,000

= 6.20

690


1. d.

0 .000

0 .200

0 .400

0 .600

0 .800

1 .000

1 .200

1 .400

1 .600

2006 2005 2004 2003 2002

Y ear

Rat

io o

f lia

bilit

ies

to s

tock

hold

ers'

equ

ity

Industry ra tio o fliab ilities tostockho lders'equity

S age ratio o fliab ilities tostockho lders'equity

Ratio of liabilities to stockholders’ equity: equity rs'stockholde Total

sliabilitie Total

2006: $4,000,000$2,000,000

= 0.50 2003: $1,400,000$1,200,000

= 0.86

2005: $2,800,000$1,700,000

= 0.61 2002: $1,000,000$1,000,000

= 1.00

2004: $2,000,000$1,500,000

= 0.75

Note: The total liabilities are the difference between the total assets and total

stockholders’ equity ending balances.

691

Prob. 15–5A Concluded

2. Both the rate earned on total assets and rate earned on stockholders’ equity are above the industry average for all five years. The rate earned on total as-sets is actually improving gradually. The rate earned on stockholders’ equity exceeds the rate earned on total assets, providing evidence of the positive use of leverage. The company is clearly growing earnings as fast as the asset and equity base. In addition, the ratio of liabilities to stockholders’ equity in-dicates that the proportion of debt to stockholders’ equity has been declining over the period. The firm is adding to debt at a slower rate than the assets are growing from earnings. The number of time interest charges were earned ra-tio is improving during this time period. Again, the firm is increasing earnings faster than the increase in interest charges. Overall, these ratios indicate ex-cellent financial performance coupled with appropriate use of debt (leverage).

692

Prob. 15–1B

1. PET CARE, INC.


Increase (Decrease) 2006 2005 Amount Percent

Sales................................................. $ 76,200 $ 61,000 $ 15,200 24.92% Sales returns and allowances........ 1,200 1,000 200 20.00% Net sales .......................................... $ 75,000 $ 60,000 $ 15,000 25.00% Cost of goods sold.......................... 42,000 35,000 7,000 20.00% Gross profit...................................... $ 33,000 $ 25,000 $ 8,000 32.00% Selling expenses ............................. $ 13,800 $ 12,000 $ 1,800 15.00% Administrative expenses ................ 9,000 8,000 1,000 12.50% Total operating expenses............... $ 22,800 $ 20,000 $ 2,800 14.00% Income from operations ................. $ 10,200 $ 5,000 $ 5,200 104.00% Other income ................................... 500 500 0 0.00% Income before income tax.............. $ 10,700 $ 5,500 $ 5,200 94.55% Income tax expense ........................ 2,400 1,200 1,200 100.00% Net income....................................... $ 8,300 $ 4,300 $ 4,000 93.02% 2. The profitability has significantly improved. Net sales have increased by 25%

over the 2005 base year. In addition, however, cost of goods sold, selling ex-penses, and administrative expenses grew at a slower rate. Increasing sales combined with costs that increase at a slower rate results in strong earnings growth. In this case, net income grew in excess of 93% over the base year.

693

Prob. 15–2B

1. INDUSTRIAL SANITATION SYSTEMS, INC.



Sales.................................................... $ 144,000 102.86% $ 128,000 102.40% Sales returns and allowances........... 4,000 2.86 3,000 2.40 Net sales ............................................. $ 140,000 100.00% $ 125,000 100.00% Cost of goods sold............................. 80,000 57.14 72,000 57.60 Gross profit......................................... $ 60,000 42.86% $ 53,000 42.40% Selling expenses ................................ $ 56,000 40.00% $ 30,000 24.00% Administrative expenses ................... 14,000 10.00 12,000 9.60 Total operating expenses.................. $ 70,000 50.00% $ 42,000 33.60% Income from operations .................... $ (10,000) (7.14)% $ 11,000 8.80% Other income ...................................... 2,000 1.43 1,800 1.44 Income before income tax................. $ (8,000) (5.71)% $ 12,800 10.24% Income tax expense (benefit) ............ (2,000) (1.43) 3,000 2.40 Net income (loss) ............................... $ (6,000) (4.28)%* $ 9,800 7.84%

*Rounded down 2. The net income as a percent of sales has declined. All the costs and ex-

penses, other than selling expenses, have maintained their approximate cost as a percent of sales relationship between 2005 and 2006. Selling expenses as a percent of sales, however, have grown from 24% to 40% of sales. Appar-ently, the new advertising campaign has not been successful. The increased expense has not produced sufficient sales to maintain relative profitability. Thus, selling expenses as a percent of sales have increased.

694

Prob. 15–3B

1. a. Working capital = Current assets – Current liabilities $594,000 – $269,000 = $325,000

b. Current ratio = Current assetsCurrent liabilities

$269,000$594,000

= 2.21

c. Quick ratio = Quick assetsCurrent liabilities

$269,000

$185,000 + $56,000 + $120,000 = 1.34

2. Supporting Calculations Working Current Quick Current Quick Current Transaction Capital Ratio Ratio Assets Assets Liabilities

a. $325,000 2.21 1.34 $594,000 $361,000 $269,000 b. 325,000 2.56 1.44 534,000 301,000 209,000 c. 325,000 2.05 1.17 634,000 361,000 309,000 d. 325,000 2.31 1.37 574,000 341,000 249,000 e. 300,000 2.02 1.23 594,000 361,000 294,000 f. 325,000 2.21 1.34 594,000 361,000 269,000 g. 445,000 2.65 1.79 714,000 481,000 269,000 h. 325,000 2.21 1.34 594,000 361,000 269,000 i. 425,000 2.58 1.71 694,000 461,000 269,000 j. 325,000 2.21 1.31 594,000 352,000 269,000

695

Prob. 15–4B

1. Working capital: $945,000 – $285,000 = $660,000

Calculated Ratio Numerator Denominator Value

2. Current ratio .................. $945,000 $285,000 3.3 3. Quick ratio ..................... $600,000 $285,000 2.1 4. Accounts receivable turnover ......................... $2,800,000 ($158,000 + $172,000)/2 17.0 5. Number of days' sales in receivables ................ $172,000 ($2,800,000/365) 22.4 6. Inventory turnover......... $1,250,000 ($265,000 + $325,000)/2 4.2 7. Number of days' sales in inventory.................... $325,000 ($1,250,000/365) 94.9 8. Fixed assets to long- term liabilities................ $2,100,000 $900,000 2.3 9. Liabilities to stockholders' equity............... $1,185,000 $2,110,000 0.6 10. Number of times interest charges earned.............. $501,000 + $79,000 $79,000 7.3 11. Number of times preferred dividends earned ............................ $361,000 $32,000 11.3 12. Ratio of net sales to assets............................. $2,800,000 ($3,045,000 + $2,170,000)/2 1.1 13. Rate earned on total assets............................. $361,000 + $79,000 ($3,295,000 + $2,370,000)/2 15.5% 14. Rate earned on stockholders' equity............... $361,000 ($2,110,000 + $1,745,000)/2 18.7% 15. Rate earned on common stockholders' equity............... ($361,000 – $32,000) ($1,710,000 + $1,445,000)/2 20.9% 16. Earnings per share on common stock.......... ($361,000 – $32,000) 80,000 $4.11 17. Price-earnings ratio....... $64.00 $4.11 15.6 18. Dividends per share of common stock .......... $64,000 80,000 $0.80 19. Dividend yield................ $0.80 $64.00 1.25%

696

Prob. 15–5B

1. a.

0.00

0.05

0.10

0.15

0.20

0.25

0.30

2006 2005 2004 2003 2002

Year

Rat

e ea

rned

on

tota

l ass

ets

Industry rate earned on total assets

Crane rate earned on total assets

Rate earned on total assets = assets total Average

expenseInterest incomeNet ++++

2006: $1,550,000$132,000

= 0.09 2003: $1,100,000$230,000

= 0.21

2005: $1,425,000$145,000

= 0.10 2002: $900,000$225,000

= 0.25

2004: $1,275,000$185,000

= 0.15

697

Prob. 15–5B Continued

1. b.

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

2006 2005 2004 2003 2002

Year

Rat

e ea

rned

on

stoc

khol

ders

' equ

ity

Industry rate earned on stockholders' equity

Crane rate earned on stockholders' equity

Rate earned on stockholders’ equity = equity rs'Stockholde

incomeNet

2006: $565,000$30,000

= 0.05 2003: $325,000$150,000

= 0.46

2005: $525,000$50,000

= 0.10 2002: $225,000$150,000

= 0.67

2004: $450,000$100,000

= 0.22

698


1. c.

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

2006 2005 2004 2003 2002

Year

Num

ber

of ti

mes

inte

rest

cha

rges

ear

ned

Industry number of times interest charges are earned

Crane number of times interest charges are earned

earned were

chargesinterest times of Number =

expenseInterest expenseInterest expense tax Income incomeNet ++++++++

2006: $102,000$141,000

= 1.38 2003: $80,000

$275,000 = 3.44

2005: $95,000

$160,000 = 1.68 2002:

$75,000$270,000

= 3.60

2004: $85,000

$215,000 = 2.53

699


1. d.

0.500

1.000

1.500

2.000

2.500

3.000

3.500

2006 2005 2004 2003 2002

Year

Rat

io o

f lia

bilit

ies

to s

tock

hold

ers'

equ

ity

Industry ratio of liabilities to stockholders' equityCrane ratio of liabilities to stockholders' equity

Ratio of liabilities to stockholders’ equity = equity rs'stockholde Total

sliabilitie Total

2006: $580,000

$1,020,000 = 1.76 2003:

$400,000$800,000

= 2.00

2005: $550,000$950,000

= 1.73 2002: $250,000$750,000

= 3.00

2004: $500,000$850,000

= 1.70

Note: Total liabilities are determined by subtracting stockholders’ equity (end-ing balance) from the total assets (ending balance).

700

Prob. 15–5B Concluded

2. Both the rate earned on total assets and the rate earned on stockholders’ equity have been moving in a negative direction in the last five years. Both measures have moved below the industry average over the last two years. The cause of this decline is driven by a rapid decline in earnings. The use of debt can be seen from the ratio of liabilities to stockholders’ equity. The ratio has declined over the time period and has declined below the industry average. Thus, the level of debt relative to the stockholders’ equity has gradually improved over the five years. Unfortunately, the earnings have declined at a faster rate, causing the rate earned on stockholders’ equity to decline. The rate earned on total assets ran below the interest cost on debt in 2006, causing the rate earned on stockholders’ equity to drop below the rate earned on total assets. This is an example of negative leverage. The number of times interest charges were earned has been falling below the industry average for several years. This is the result of low profitability combined with high interest costs (10%). The number of times interest is earned has fallen to a dangerously low level in 2006. The low profitability and time interest charges are earned in 2006, as well as the five-year trend, should be a major concern to the company’s management, stockholders, and creditors.

701

HOME DEPOT, INC., PROBLEM

1. a. Working capital (in millions): 2003: $3,882 ($11,917 – $8,035) 2002: $3,860 ($10,361 – $6,501) b. Current ratio: 2003: 1.48 ($11,917 ÷ $8,035) 2002: 1.59 ($10,361 ÷ $6,501) c. Quick ratio: 2003: 0.41 ($3,325 ÷ $8,035) 2002: 0.53 ($3,466 ÷ $6,501) d. Accounts receivable turnover: 2003: 58.48 {$58,247 ÷ [($920 + $1,072)/2]} 2002: 61.03 {$53,553 ÷ [($835 + $920)/2]} e. Number of days' sales in receivables: 2003: 6.72 [$1,072 ÷ ($58,247/365)] 2002: 6.27 [$920 ÷ ($53,553/365)] f. Inventory turnover: 2003: 5.33 {$40,139 ÷ [($8,338 + $6,725)/2]} 2002: 5.63 {$37,406 ÷ [($6,725 + $6,556)/2]} g. Number of days' sales in inventory: 2003: 75.82 days [$8,338 ÷ ($40,139/365)] 2002: 65.62 days [$6,725 ÷ ($37,406/365)] h. Ratio of liabilities to stockholders’ equity: 2003: 0.52 ($10,209 ÷ $19,802) 2002: 0.46 ($8,312 ÷ $18,082) i. Ratio of net sales to average total assets: 2003: 2.07 {$58,247 ÷ [($30,011 + $26,394)/2]} 2002: 2.24 {$53,553 ÷ [($26,394 + $21,385)/2]} j. Rate earned on average total assets: 2003: 13.12% {($3,664 + 37) ÷ [($30,011 + $26,394)/2)]} 2002: 12.86% {($3,044 + 28) ÷ [($26,394 + $21,385)/2)]} k. Rate earned on average common stockholders’ equity: 2003: 19.34% {$3,664 ÷ [($19,802 + $18,082)/2]} 2002: 18.4% {$3,044 ÷ [($18,082 + $15,004)/2]}

702

Home Depot, Inc., Problem Continued

l. Price-earnings ratio: 2003: 13.66 ($21.31 ÷ $1.56) 2002: 38.53 ($49.70 ÷ $1.29) m. Percentage relationship of net income to net sales: 2003: 6.29% ($3,664 ÷ $58,247) 2002: 5.68% ($3,044 ÷ $53,553) 2. Before reaching definitive conclusions, each measure should be compared

with past years, industry averages, and similar firms in the industry. a. The working capital increased slightly.

b. and c. The working capital and the quick ratio declined modestly during 2003.

d. and e. The accounts receivable turnover and number of days’ sales in re-

ceivables indicate a slight decrease in the efficiency of collecting ac-counts receivable. The accounts receivable turnover decreased from 61.03 to 58.48. The number of days’ sales in receivables increased from 6.27 to 6.72. Both measures indicate, however, that Home Depot has significant cash sales, since the turnover is so high and the av-erage collection period is so short. If the credit sales were known, these ratios could be calculated with net credit sales on account in the numerator. The resulting calculations could be compared to Home Depot’s credit policy.

f. and g. The results of these two analyses showed a decrease in the inven-

tory turnover and an increase in the number of days’ sales in inven-tory. Both trends are unfavorable. Inventory management is critical to a retailer, so this ratio trend would warrant further analysis.

h. The margin of protection to the creditors improved slightly in 2003. Overall,

there is excellent protection to creditors. i. These analyses indicate a decrease in the effectiveness in the use of the

assets to generate revenues. j. The rate earned on average total assets improved slightly during 2003.

Overall, rates earned on assets that exceed 10% is usually considered good performance.

k. The rate earned on average common stockholders’ equity in 2003 also in-

creased. This is also evidence of the positive use of leverage, since the rate earned on stockholders’ equity exceeds the rate earned on assets. The rates earned on average common stockholders’ equity shown for these two years would be considered excellent performance.

703

Home Depot, Inc., Problem Concluded

l. The price-earnings ratio dropped significantly from 2002 to 2003. This drop accompanied an overall drop in price-earnings ratios for the whole market during this time. In addition, market participants are revaluing Home De-pot’s growth prospects downward in light of the competition from Lowe’s. Thus, even though earnings increased, the stock price declined.

m. The percent of net income to net sales increased, from 5.68% to 6.29%, a

favorable trend.

704

SPECIAL ACTIVITIES

Activity 15–1

This position does not allow the shareholders to take advantage of leverage. As a result, the return on shareholders' equity cannot be improved by using debt. On the flip side, a low or no debt load does provide the company great flexibility in the case of a national calamity. However, the “no debt” position only makes sense within the “national calamity” scenario. Within normal business opera-tions, most companies can assume some debt without much loss of flexibility or control. Ice Mountain Brewery is competing against companies that will not be so inclined to avoid debt. As a result, they will likely be able to grow faster than Ice Mountain. The Ice Mountain management should consider the risk of not being able to keep up with the competition because of their conservative financing policies.

Activity 15–2

Sandra is concerned about the inventory and accounts receivable levels because she must determine their value. Inventory that cannot be sold (or sold at a large discount) or accounts receivable that cannot be collected must be written down to reflect their reduced value. Sandra has conducted the ratio analysis and inter-viewed Travis to help make this determination. The inventory and accounts re-ceivable levels have grown alarmingly. Travis’s response to Sandra is not reas-suring. The inventory represents obsolete technology that is left over after the holiday season. The accounts receivable have apparently grown from loosening the credit standards. Sandra may need to insist on write-downs of the inventory and accounts receivable balances to reflect their net realizable values. Travis is correct in pointing out that the current ratio has probably improved. Thus, al-though Travis calls this “good,” it is only such if the current assets in the nu-merator are fairly valued. Under these circumstances, the current ratio is proba-bly overstated because the inventory and accounts receivable balances are in-flated relative to their net realizable values.

705

Activity 15–3

Common-Size Statements Dell Computer Corp. and Apple Computer Co.

Dell Computer Apple Computer For Year Ended For Year Ended Feb. 1, 2002 Sept. 29, 2001

Sales (net) ................................................... 100.00% 100.00% Cost of goods sold..................................... 82.33 76.97 Gross profit................................................. 17.67% 23.03% Operating expenses: Selling, general, and administrative.... 8.93% 21.22% Research and development ................. 1.45 8.02 Special charges .................................... 1.55 0.21 Total operating expenses................. 11.93% 29.44% Operating income....................................... 5.74% (6.41%) The common size analysis indicates that Dell and Apple are very different computer companies. Dell's income from operations is 5.74% of sales, while Apple's was a –6.41% of sales. There is a over a 12 percentage point difference between the two companies. What explains this difference? The gross profit for Dell was 17.67% of sales, which is fairly narrow. Apple, in contrast, had a gross profit of 23.03% of sales, which is over 5 points better than Dell's. This suggests Apple is able to charge higher prices than Dell for its products (assuming that they are both equally efficient in making products). Apple's selling, general, and administrative expenses are at about 21.22% of sales, while Dell's is only 8.93% of sales. Dell designed the business for efficiency, thus it operates on a low cost structure. The selling, gen-eral, and administrative expenses do not include expensive advertising campaigns, complex sales channel administration, or complex product support activities. Ap-ple, in contrast, has very large selling, general, and administrative costs as a per-cent of sales. It attempts to sell a unique machine to a unique audience. This re-quires significant SG&A effort. Another big difference between the two companies is in research and development. Dell's R&D is a narrow 1.45% of sales, while Ap-ple's is a robust 8.02% of sales. Essentially, Dell focuses its R&D effort on the final assembly of the computer. Dell relies on its suppliers to develop innovation in the components and operating system software (Microsoft). Apple, on the other hand, must constantly spend R&D on computers, peripherals, and its own operating sys-tem software. This is because Apple chooses not to follow the industry standards and thus must pave its own way on both hardware and software. This feature of Apple also contributes to its larger selling, general, and administrative costs as a percent of sales. The higher gross profit as a percent of sales is not enough to off-set the higher SG&A and R&D costs as a percent of sales. Thus, Apple ends up with a negative income from operations as a percent of sales.

706

Activity 15–4

1. a. Rate earned on total assets: assets total Average

incomeNet

2002: $285,882

($980) = –0.35%

2001: ($5,453)$279,967

= –1.95%

2000: $3,467

$277,305 = 1.25%

b. Rate earned on total stockholders’ equity: equity rs'stockholde total Average

incomeNet

2002: $6,688($980)

= –14.65%

2001: ($5,453)$13,198

= –41.32%

2000: $3,467

$23,107 = 15.00%

c. Earnings per share: Net income Preferred dividends


2002: 1,819

$15 ($980) −−−− = $–0.55

2001: 1,820

$15 ($5,453) −−−− = ($3.00)

2000: 1,483

$15 $3,467 −−−− = $2.33

707

Activity 15–4 Continued

d. Dividend yield: stock common of share per priceMarket

stock common of share per Dividend

2002: $13.57$0.40

= 2.95%

2001: $1.05

$21.32 = 4.92%

2000: $1.80

$24.10 = 7.47%

e. Price-earnings ratio: Market price per share of common stock

Earnings per share of common stock

2002: $0.55$13.57

= undefined

2001: $21.32($3.00)

= undefined

2000: $24.10$2.33

= 10.34

2. Ratio of average liabilities to average stockholders’ equity = Average liabilities ÷

Average stockholders’ equity

2002: $6,688

$6,688 $285,882 −−−− = 41.75 (or 4,175% of stockholders’ equity)

708

Activity 15–4 Concluded

3. Ford’s leverage is the result of its financing arm. The nature of financial insti-tutions is to acquire debt money at a low interest rate and lend it out at a higher interest rate. This is inherently a low risk business that allows financial institutions to acquire extensive debt resources with very little equity. Banks acquire deposits (debt) in this manner. Thus, financial institutions often have equity less than 10% of total assets. Ford’s financing business skews the ratio of liabilities to stockholders’ equity so that it does not appear like a normal manufacturer.

4. Ford’s profitability plummeted from 2000 levels as the recession in 2001 ar-rived. The rate earned on total assets and rate earned on stockholders’ equity fell dramatically. As a result of this huge drop in business fortunes, Ford had to systematically cut the dividend, which reduced the dividend yield, even though the stock price was dropping. The price-earnings (P/E) ratio is interest-ing. In 2000, the P/E ratio was a very low 10.34. Thus, Ford had excellent earn-ings, but the market did not reward the company with a high stock price. In 2001 and 2002, Ford had net losses, causing the P/E ratio to become unde-fined because the earnings per share was negative. Shareholders know from history that Ford is a cyclical business. When the economy is going well, the market price will not bid up the stock price with the earnings, causing the P/E ratio to be depressed. In a sense, stockholders know it is only a matter of time before fortunes reverse. When the economy moves into recession, the stock price drops, but not as dramatically as the profitability. That is, the stock price cannot become negative (or zero). Again, stockholders know it is only a matter of time before economic fortunes reverse back up.

709

Activity 15–5

The following is an example of a solution. A student’s actual solution will depend on the year of analysis.

710

Activity 15–6

1.

a. Rate earned on total assets: assets total Average

incomeNet

Marriott: $236

$8,673 = 2.72%

Hilton: $176

$8,963 = 1.96%

b. Rate earned on total stockholders’ equity: equity rs'stockholde total Average

incomeNet

Marriott: $236

$3,373 = 7.00%

Hilton: $176

$1,713 = 10.27 %

c.

:earned are charges

interest times of Number

expenseInterest

expenseInterest expense tax income before Income ++++

Marriott: $109

$109 $370 ++++ = 4.39

Hilton: $237

$237 $306 ++++ = 2.29

d. Ratio of liabilities to stockholders’ equity: equity rs'stockholde Total

sliabilitie Total

Marriott: $5,629$3,478

= 1.62

Hilton: $1,642$7,498

= 4.57

711

Activity 15–6 Concluded

Summary Table:

Marriott Hilton Rate earned on total assets 2.72% 1.96% Rate earned on stockholders’ equity 7.00% 10.27% Number of times interest charges are earned 4.39 2.29 Ratio of liabilities to stockholders’ equity 1.62 4.57

2. Marriott earns a higher rate earned on total assets (2.72% vs. 1.96%), but a

lower rate on stockholders’ equity (7.00% vs. 10.27%), compared to Hilton. The reason can be seen with the leverage formula. Marriott has less leverage than does Hilton. This is confirmed by the ratio of liabilities to stockholders’ equity, which shows the relative debt held by Marriott is 1.62 times the stock-holders’ equity, compared to 4.57 times for Hilton. Can Hilton manage this much debt? The number of times interest charges are earned shows that Mar-riott covers its interest charges 4.39 times. The comparable ratio for Hilton is 2.29. Hilton’s operating income (before interest and taxes) is over twice its in-terest charges, which is marginal, but sufficient. Hilton’s debt capacity is near a maximum. In sum, Hilton earns a higher return for stockholders, but with greater risk.

financial ratios

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