MBA_620_Project 1_Analyzing Financial Statements
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Project 1: Analyzing Financial Statements
MBA620 Project 1 Introduction
In project 1, assume you are a free-lance consultant for Maryland Creative Solutions, a fictional company. The assignment will require you to examine the firm's declining financial health and find ways to reverse this trend.
During the course of this project, analyze the firm’s balance sheet, income statements, and cash flows to
form strategies for a successful future for the firm. Regularly review your syllabus and class announcements to submit your project on time and meet the grading criteria. If at any point during your project you need clarity, reach out to your course instructor. We want you to do well and utilize all your available resources.
Best of luck on project 1.
Scenario
You have been chosen to join a team of consultants at Maryland Creative Solutions (MCS). Congratulations on your hiring! The group you will be working with has a history of helping transform troubled companies into profitable enterprises with a promising future. Your team is assigned to a client
firm, Largo Global Inc. (LGI). LGI's operational efficiency has declined over the past three years. The company's board of directors has hired MCS to uncover the underlying issues and make recommendations to turn things around.
What's New
2: The Financial System and the Level of Interest Rates
3: Financial Statements, Cash Flows, and Taxes
4: Analyzing Financial Statements
Financial Statements, Cash Flows, and Taxes
Learning Objectives
Discuss generally accepted accounting principles (GAAP) and their importance to the economy.
Explain the balance sheet identity and why a balance sheet must balance.
Describe how market-value balance sheets differ from book-value balance sheets.
Identify the basic equation for the income statement and the information it provides.
Understand the calculation of cash flows from operating, investing, and financing activities required
in the statement of cash flows.
Explain how the four major financial statements discussed in this chapter are related.
Identify the cash flow to a firm's investors using its financial statements.
Discuss the difference between average and marginal tax rates.
1
On July 20, 2010, after the close of U.S. financial markets, Apple Inc. announced that its corporate
earnings for the quarter ended June 26, 2010 were $3.253 billion, or $3.51 per common share
outstanding. This was considerably greater than the $3.08 per share that financial analysts covering
Apple were expecting. As a result, Apple's stock price jumped at the news, trading from a low of $240.65
per share on July 20 to a high of $265.22 the next morning. Apple attributed its strong earnings during
the period to higher than expected sales of its products, including the newly released iPhone 4 and iPad
devices.
This example illustrates the relation between the information contained in a firm's accounting
statements and its stock performance. Public corporations in the U.S. communicate their financial
performance to their investors through their financial statements, leading to Wall Street's virtual
obsession with accounting earnings. Analysts estimate how much firms should earn in a particular
reporting period, and firms that fail to meet these estimates can be punished by falling stock prices. If a
firm consistently fails to meet these estimates, its CEO can be out of a job. Pressure to meet analyst
expectations has occasionally led managers to misstate accounting results in efforts to mislead analysts
and investors. In the wake of several especially large-scale accounting frauds, involving firms such as
Enron and WorldCom, Congress and federal regulators tightened accounting standards and oversight of
the accounting profession in the early 2000s. Passage of the SarbanesOxley Act, discussed in Chapter 1
,
is an example of these steps.
Clearly, the correct preparation of financial statements is crucial for investors. In this chapter and the
next, we focus on the preparation, interpretation, and limitations of financial statements. The concepts
that we discuss in these chapters provide an important foundation for the material discussed in the rest
of this book.
CHAPTER PREVIEW
In Chapter 1
we noted that all businesses have owners and stakeholders—managers, creditors,
suppliers, and the government, among others—who have claims on the firms' cash flows. The owners
and stakeholders in a firm need to monitor the firm's progress and evaluate its performance. Financial
statements enable them to do this. The accounting system is the framework that gathers information
about the firm's business activities and translates the information into objective numerical financial
reports.
Most firms prepare financial statements on a regular basis and have independent auditors certify that
the financial statements have been prepared in accordance with generally accepted accounting
principles and contain no material misstatements. The audit increases the confidence of the owners and
stakeholders that the financial statements prepared by management present a “fair and accurate”
picture of the firm's financial condition at a particular point in time. In fact, it is difficult to get any type
of legitimate business loan without audited financial statements.
This chapter reviews the basic structure of a firm's financial statements and explains how the various
statements fit together. It also explains the relation between accounting earnings and cash flow to
investors. We examine the preparation of the balance sheet, the income statement, the statement of
retained earnings, and the statement of cash flows. As you read through this part of the chapter, pay
particular attention to the differences between (1) book value and market value and (2) accounting
2
income and cash flow to investors. Understanding the differences between these concepts is necessary
to avoid serious analytical and decision-making errors. The last part of the chapter discusses essential
features of the federal tax code for corporations. In finance we make most decisions on an after-tax
basis, so understanding the tax code is very important.
3.1 FINANCIAL STATEMENTS AND ACCOUNTING PRINCIPLES
Before we can meaningfully interpret and analyze financial statements, we need to understand some
accounting principles that guide their preparation. Thus, we begin the chapter with a discussion of
generally accepted accounting principles, which guide firms in the preparation of financial statements.
First, however, we briefly describe the annual report.
The Annual Report
The
annual report
is the most important report that firms issue to their stockholders and make available
to the general public. Historically, annual reports were dull, black-and-white publications that presented
audited financial statements for firms. Today some annual reports, especially those of large public
companies, are slick, picture-laden, glossy “magazines” in full color with orchestrated media messages.
Annual reports typically are divided into three distinct sections. First are the financial tables, which
contain financial information about the firm and its operations for the year, and an accompanying
summary explaining the firm's performance over the past year. For example, the summary might explain
that sales and profits were down because of declining consumer demand in the wake of the 2008
financial crisis. Often, there is a letter from the chairman or CEO that provides some insights into the
reasons for the firm's performance, a discussion of new developments, and a high-level view of the
firm's strategy and future direction. It is important to note that the financial tables are historical records
reflecting past performance of the firm and do not necessarily indicate what the firm will do in the
future.
To find annual reports and other corporate filings for U.S. corporations, visit the EDGAR search
page
maintained
by
the
U.S.
Securities
and
Exchange
Commission
(SEC)
at http://www.sec.gov/edgar.shtml
.
The second part of the report is often a corporate public relations piece discussing the firm's product
lines, its services to its customers, and its contributions to the communities in which it operates.
The third part of the annual report presents the audited financial statements: the balance sheet, the
income statement, the statement of retained earnings, and the statement of cash flows. Overall, the
annual report provides a good overview of the firm's operating and financial performance and states
why, in management's judgment, things turned out the way they did.
Generally Accepted Accounting Principles
3
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In the United States, accounting statements are prepared in accordance with
generally accepted
accounting principles (GAAP)
, a set of widely agreed-upon rules and procedures that define how
companies are to maintain financial records and prepare financial reports. These principles are
important because without them, financial statements would be less standardized. Accounting
standards such as GAAP make it easier for analysts and management to make meaningful comparisons
of a company's performance against that of other companies.
generally accepted accounting principles (GAAP)
a set of rules that defines how companies are to prepare financial statements
You can find more information about FASB at http://www.fasb.org
.
Accounting principles and reporting practices for U.S. firms are promulgated by the Financial
Accounting Standards Board (FASB), a not-for-profit body that operates in the public interest. FASB
derives its authority from the Securities and Exchange Commission (SEC). GAAP and reporting practices
are published in the form of FASB statements, and certified public accountants are required to follow
these statements in their auditing and accounting practices.
Fundamental Accounting Principles
To better understand financial statements, it is helpful to look at some fundamental accounting
principles embodied in GAAP. These principles determine the manner of recording, measuring, and
reporting company transactions. As you will see, the practical application of these principles requires
professional judgment, which can result in considerable differences in financial statements.
The Assumption of Arm's-Length Transactions
Accounting is based on the recording of economic transactions that can be quantified in dollar amounts.
It assumes that the parties to a transaction are economically rational and are free to
act independently
of each other. To illustrate, let's assume that you are preparing a personal balance
sheet for a bank loan on which you must list all your assets. You are including your BMW 325 as an
asset. You bought the car a few months ago from your father for $3,000 when the retail price of the car
was $15,000. You got a good deal. However, the price you paid, which would be the number recorded
on your balance sheet, was not the market price. Since you did not purchase the BMW in an arm's-
length transaction, your balance sheet would not reflect the true value of the asset.
The Cost Principle
Generally, the value of an asset that is recorded on a company's “books” reflects its historical cost. The
historical cost is assumed to represent the fair market value of the item at the time it was acquired and
is recorded as the
book value
. Over time, it is unlikely that an asset's book value will be equal to its
market value because market values tend to change over time. The major exception to this principle is
4
marketable securities, such as the stock of another company, which are recorded at their current market
value.
book value
the net value of an asset or liability recorded on the financial statements—normally reflects historical
cost
It is important to note that accounting statements are records of past performance; they are based
on historical costs, not on current market prices or values. Accounting statements translate the
business's past performance into dollars and cents, which helps management and investors better
understand how the business has performed in the past.
The Realization Principle
Under the realization principle, revenue is recognized only when the sale is virtually completed and the
exchange value for the goods or services can be reliably determined. As a practical matter, this means
that most revenues are recognized at the time of sale whether or not cash
is actually received. At this
time, if a firm sells to its customers on credit, an account receivable is recorded. The firm receives the
cash only when the customer actually makes the payment. Although the realization principle concept
seems straightforward, there can be considerable ambiguity in its interpretation. For example, should
revenues be recognized when goods are ordered, when they are shipped, or when payment is received
from the customer?
The Matching Principle
Accounting tries to match revenue on the income statement with the expenses incurred to generate the
revenue. In practice, this principle means that revenue is first recognized (according to the realization
principle) and then is matched with the costs associated with producing the revenue. For example, if we
manufacture a product and sell it on credit (accounts receivable), the revenue is recognized at the time
of sale. The expenses associated with manufacturing the product—expenditures for raw materials,
labor, equipment, and facilities—will be recognized at the same time. Notice that the actual cash
outflows for expenses may not occur at the same time the expenses are recognized. It should be clear
that the figures on the income statement more than likely will not correspond to the actual cash inflows
and outflows during the period.
The Going Concern Assumption
The going concern assumption is the assumption that a business will remain in operation for the
foreseeable future. This assumption underlies much of what is done in accounting. For example,
suppose that Kmart has $4.6 billion of inventory on its balance sheet, representing what the firm
actually paid for the inventory in arm's-length transactions. If we assume that Kmart is a going concern,
the balance sheet figure is a reasonable number because in the normal course of business we expect
Kmart to be able to sell the goods for its cost plus some reasonable markup.
5
However, suppose Kmart declares bankruptcy and is forced by its creditors to liquidate its assets. If
this happens, Kmart is no longer a going concern. What will the inventory be worth then? We cannot be
certain, but 50 cents on the dollar might be a high figure. The going concern assumption allows the
accountant to record assets at cost rather than their value in a liquidation sale, which is usually much
less.
You can see that the fundamental accounting principles just discussed leave considerable professional
discretion to accountants in the preparation of financial statements. As a result, financial statements can
and do differ because of honest differences in professional judgments. Of course, there are limits on
honest professional differences, and at some point, an accountant's choices can cross a line and result in
“cooking the books.”
International GAAP
Accounting is often called the language of business. Just as there are different dialects within languages,
there are different international “dialects” in accounting. For example, the set of generally accepted
accounting principles in the United Kingdom is called U.K. GAAP. Given the variation in accounting
standards, accountants must adjust financial statements so that meaningful comparisons can be made
between firms that utilize different sets of accounting principles. The cost of making these adjustments
represents an economic inefficiency that adds to the overall cost of international business transactions.
By the end of the 1990s, the two predominant international reporting standards were the U.S. GAAP
and the International Financial Reporting Standards, also known as IFRS. Both FASB and
the International Accounting Standards Board (IASB)
have been working toward a convergence of these
rules in an effort to provide a truly global accounting standard. Consistent with these efforts, the U.S.
SEC is reviewing proposals for U.S. corporations to adopt IFRS for financial reporting by as early as 2015.
Today most international jurisdictions already utilize IFRS or some close variant of those standards.
You can read more about IFRS at http://www.ifrs.com
.
Illustrative Company: Diaz Manufacturing
In the next part of the chapter, we turn to a discussion of four fundamental financial statements: the
balance sheet, the income statement, the statement of retained earnings, and the statement of cash
flows. To more clearly illustrate these financial statements, we use data from Diaz Manufacturing
Company, a fictional Houston-based provider of petroleum and industrial equipment and services
worldwide.
1
Diaz Manufacturing was formed in 2003 as a spin-off of several divisions of Cooper
Industries. The firm specializes in the design and manufacturing of systems used in petroleum
production and has two divisions: (1) Diaz Energy Services, which sells oil and gas compression
equipment, and (2) Diaz Manufacturing, which makes valves and related parts for energy production.
In 2011 Diaz Manufacturing's sales increased to $1.56 billion, an increase of 12.8 percent from the
previous year. A letter to stockholders in the 2011 annual report stated that management did not expect
earnings in 2012 to exceed the 2011 earnings. The reason for caution was that Diaz's earnings are very
6
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susceptible to changes in the political and economic environment in the world's energy-producing
regions, and in 2011 the environment in the Middle East was highly unstable. Management reassured
investors, however, that Diaz had the financial strength and the management team needed to weather
any economic adversity.
> BEFORE YOU GO ON
1.
What types of information does a firm's annual report contain?
2.
What is the realization principle, and why may it lead to a difference in the timing of when revenues are recognized on the books and cash is collected?
3.2 THE BALANCE SHEET
The balance sheet
reports the firm's financial position at a particular point in time. Exhibit 3.1
shows the
balance sheets for Diaz Manufacturing on December 31, 2010 and December 31, 2011. The left-hand
side of the balance sheet identifies the firm's assets, which are listed at book value. These assets are
owned by the firm and are used to generate income. The right-hand side of the balance sheet includes
liabilities and stockholders' equity, which tell us how the firm has financed its assets. Liabilities are
obligations of the firm that represent claims against its assets. These claims arise from debts and other
obligations to pay creditors, employees, or the government. In contrast, stockholders' equity represents
the residual claim of the owners on the remaining assets of the firm after all liabilities have been
paid.
2
The basic balance sheet identity can thus be stated as follows:
3
balance sheet
financial statement that shows a firm's financial position (assets, liabilities, and equity) at a point in time
You can go to Yahoo! Finance to obtain financial statements and other information about public
companies at http://finance.yahoo.com
.
Since stockholders' equity is the residual claim, stockholders would receive any remaining value if the
firm decided to sell off all of its assets and use the money to pay its creditors. That is why the balance
sheet always balances. Simply put, if you total what the firm owns and what it owes, then the difference
between the two is the total stockholders' equity:
Notice that total stockholders' equity can be positive, negative, or equal to zero.
It is important to note that balance sheet items are listed in a specific order. Assets are listed in order
of their liquidity, with the most liquid assets, cash and marketable securities, at the top. The liquidity of
7
an asset is defined by how quickly it can be converted into cash without loss of value. Thus, an asset's
liquidity has two dimensions: (1) the speed and ease with which the asset can be sold and (2) whether
the asset can be sold without loss of value. Of course, any asset can be sold easily and quickly if the price
is low enough. Liabilities on the balance sheet are listed based on their maturity, with the liabilities
having the shortest maturities listed at the top. Maturity refers to the length of time remaining before
the obligation must be paid.
EXHIBIT 3.1 Diaz Manufacturing Balance Sheets as of December 31 ($ millions)
The left-hand side of the balance sheet lists the assets that the firm has at a particular point in time,
while the right-hand side shows how the firm has financed those assets.
a
Cash includes investments in marketable securities.
b
10,000,000 preferred stock shares authorized.
c
150,000,000 common stock shares authorized.
Next, we examine some important balance sheet accounts of Diaz Manufacturing as of December 31,
2011 (see Exhibit 3.1
). As a matter of convention, accountants divide assets and liabilities into short-
term (or current) and long-term parts. We will start by looking at current assets and liabilities.
Current Assets and Liabilities
Current assets are assets that can reasonably be expected to be converted into cash within one year.
Besides cash, which includes investments in marketable securities such as money market instruments,
other current assets are accounts receivable, which are typically due within 30 to 45 days, and
inventory, which is money invested in raw materials, work-in-process inventory, and finished goods.
Diaz's current assets total $1,039.8 million.
Current liabilities are obligations payable within one year. Typical current liabilities are accounts
payable, which arise in the purchases of goods and services from vendors and are normally paid within
8
30 to 60 days; notes payable, which are formal borrowing agreements with a bank or some other lender
that have a stated maturity; and accrued taxes from federal, state, and local governments, which are
taxes Diaz owes but has not yet paid. Diaz's total current liabilities equal $377.8 million.
Net Working Capital
Recall from
Chapter 1
that the dollar difference between total current assets and total current liabilities
is the firm's net working capital:
Net working capital is a measure of a firm's ability to meet its short-term obligations as they come due.
One way that firms maintain their liquidity is by holding more current assets.
For Diaz Manufacturing, total current assets are $1,039.8 million, and total current liabilities are
$377.8 million. The firm's net working capital is thus:
To interpret this number, if Diaz Manufacturing took its current stock of cash and liquidated its
marketable securities, accounts receivables, and inventory at book value, it would have $1,039.8 million
with which to pay off its short-term liabilities of $377.8 million, leaving $662.0 million of “cushion.” As a
short-term creditor, such as a bank, you would view the net working capital position as positive because
Diaz's current assets exceed current liabilities by almost three times ($1,039.8/$377.8 = 2.75).
Accounting for Inventory
Inventory, as noted earlier, is a current asset on the balance sheet, but it is usually the least liquid of the
current assets. The reason is that it can take a long time for a firm to convert inventory into cash. For a
manufacturing firm, the inventory cycle begins with raw materials, continues with goods in process,
proceeds with finished goods, and finally concludes with selling the asset for cash or an account
receivable. For a firm such as The Boeing Company, for example, the inventory cycle in manufacturing
an aircraft can be nearly a year.
An important decision for management is the selection of an inventory valuation method. The most
common methods are FIFO (first in, first out) and LIFO (last in, first out). During periods of changing price
levels, how a firm values its inventory affects both its balance sheet and its income statement. For
example, suppose that prices have been rising (inflation). If a company values its inventory using the
FIFO method, when the firm makes a sale, it assumes the sale is from the oldest, lowest-cost inventory
—first in, first out. Thus, during rising prices, firms using FIFO will have the lowest cost of goods sold, the
highest net income, and the highest inventory value. In contrast, a company using the LIFO method
assumes the sale is from the newest, highest-cost inventory—last in, first out. During a period of
9
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inflation, firms using LIFO will have the highest cost of goods sold, the lowest net income, and the lowest
inventory value.
Because inventory valuation methods can have a significant impact on both the income statement
and the balance sheet, when financial analysts compare different companies, they make adjustments to
the financial statements for differences in inventory valuation methods. Although firms can switch from
one inventory valuation method to another, this type of change is an extraordinary event and cannot be
done frequently.
Diaz Manufacturing reports inventory values in the United States using the LIFO method. The
remaining inventories, which are located outside the United States and Canada, are calculated using the
FIFO method. Diaz's total inventory is $423.8 million.
Long-Term Assets and Liabilities
The remaining assets on the balance sheet are classified as long-term assets. Typically, these assets are
financed by long-term liabilities and stockholders' equity.
Long-Term Assets
Long-term productive assets are the assets that the firm uses to generate most of its income. Long-term
assets may be tangible or intangible. Tangible assets are balance sheet items such as land, mineral
resources, buildings, equipment, machinery, and vehicles that are used over an extended period of time.
In addition, tangible assets can include other businesses that a firm wholly or partially owns, such as
foreign subsidiaries. Intangible assets are items such as patents, copyrights, licensing agreements,
technology, and other intellectual capital the firm owns.
Goodwill
is an intangible asset that arises only when a firm purchases another firm. Conceptually,
goodwill is a measure of how much the price paid for the acquired firm exceeds the sum of the values of
its individual assets. There are a variety of reasons why the purchase price of an asset might exceed its
value to the seller. Goodwill may arise from improvements in efficiency, the reputation or brands
associated with products or trademarks, or even a valuable client base for a particular service. For
example, if Diaz Manufacturing paid $2.0 million for a company that had individual assets with a total
fair market value of $1.9 million, the goodwill premium paid would be $100,000 ($2.0 million—$1.9
million = $0.1 million).
Diaz Manufacturing's long-term assets comprise net plant and equipment of $399.4 million and
intangible and other assets of $450.0 million, as shown in Exhibit 3.1
. The term
net plant and
equipment
indicates that accumulated depreciation has been subtracted to arrive at the net value. That
is, net plant and equipment equals total plant and equipment less accumulated depreciation;
accumulated depreciation is the total amount of depreciation expense taken on plant
and equipment up
to the balance sheet date. For Diaz Manufacturing, the above method yields the following result:
10
Accumulated Depreciation
When a firm acquires a tangible asset that deteriorates with use and wears out, accountants try to
allocate the asset's cost over its useful life. The matching principle requires that the cost be expensed
during the period in which the firm benefited from use of the asset. Thus,
depreciation
allocates the
cost of a limited-life asset to the periods in which the firm is assumed to benefit from the asset. Tangible
assets with an unlimited life, such as land, are not depreciated. Depreciation affects the balance sheet
through the accumulated depreciation account; we discuss its effect on the income statement in Section
3.4.
depreciation
allocation of the cost of an asset over its estimated life to reflect the wear and tear on the asset as it is
used to produce the firm's goods and services
A company can elect whether to depreciate its assets using straight-line depreciation or one of the
approved accelerated depreciation methods. Accelerated depreciation methods allow for more
depreciation expense in the early years of an asset's life than straight-line depreciation.
Diaz Manufacturing uses the straight-line method of depreciation. Had Diaz elected to use
accelerated depreciation, the value of its depreciable assets would have been written off to the income
statement more quickly as a higher depreciation expense, which results in a lower net plant and
equipment account on its balance sheet and a lower net income for the period.
Long-Term Liabilities
Long-term liabilities include debt instruments due and payable beyond one year as well as other long-
term obligations of the firm. They include bonds, bank term loans, mortgages, and other types of
liabilities, such as pension obligations and deferred compensation. Typically, firms finance long-term
assets with long-term liabilities. Diaz Manufacturing has a single long-term liability of $574.0 million,
which is a long-term debt.
Equity
We have summarized the types of assets and liabilities that appear on the balance sheet. Now we look
at the equity accounts. Diaz Manufacturing's total stockholders' equity at the end of 2011 is $937.4
million and is made up of four accounts—common stock, additional paid-in capital, retained earnings,
and treasury stock—which we discuss next. We conclude with a discussion of preferred stock. Although
a line item for preferred stock appears on Diaz Manufacturing's balance sheets, the company has no
shares of preferred stock outstanding.
11
The Common Stock Accounts
The most important equity accounts are those related to common stock, which represent the true
ownership of the firm. Certain basic rights of ownership typically come with common stock; those rights
are as follows:
1.
The right to vote on corporate matters such as the election of the board of directors or important actions such as the purchase of another company.
2.
The preemptive right, which allows stockholders to purchase any additional shares of stock issued by the corporation in proportion to the number of shares they currently own. This allows common stockholders to retain the same percentage of ownership in the firm, if they
choose to do so.
3.
The right to receive cash dividends if they are paid.
4.
If the firm is liquidated, the right to all remaining corporate assets after all creditors and preferred stockholders have been paid.
A common source of confusion is the number of different common stock accounts on the balance
sheet, each of which identifies a source of the firm's equity. The
common stock account
identifies the
initial funding from investors that was used to start the business and is priced at
a par value. The par
value is an arbitrary number set by management, usually a nominal amount such as $1.
Clearly, par value has little to do with the market value of the stock when it is sold to investors.
The
additional paid-in capital
is the amount of capital received for the common stock in excess of par
value. Thus, if the new business is started with $40,000 in cash and the firm decides to issue 1,000
shares of common stock with a par value of $1, the owners' equity account looks as follows:
Note the money put up by the initial investors: $1,000 in total par value (1,000 shares of common stock
with a par value of $1) and $39,000 additional paid-in capital, for a total of $40,000.
As you can see in Exhibit 3.1
, Diaz manufacturing has 54,566,054 shares of common stock with a par
value of 91.63 cents, for a total value of $50.0 million (54,566,054 shares × 91.63 cents = $50 million).
The additional paid-in capital is $842.9 million. Thus, Diaz's total paid-in capital is $892.9 million ($50.0
million + $842.9 million = $892.9 million).
Retained Earnings
The retained earnings account represents earnings that have been retained and reinvested in the
business over time rather than being paid out as cash dividends. The change in retained earnings from
one period to the next can be computed as the difference between net income and dividends paid. Diaz
Manufacturing's retained earnings account is only $67.8 million. Reading the annual report, we learn
that in the recent past the company “wrote down” the value of a substantial amount of assets. This
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transaction, which will be discussed later in the chapter, also reduced the size of the retained earnings
account by reducing net income.
Note that retained earnings are not the same as cash. In fact, as we discuss in Section 3.7 of this
chapter, a company can have a very large retained earnings account and no cash. Conversely, it can have
a lot of cash and a very small retained earnings account. Because retained earnings appear on the
liability side of the balance sheet, they do not represent an asset, as do cash and marketable securities.
Treasury Stock
The
treasury stock
account represents stock that the firm has purchased back from investors. Publicly
traded companies can simply buy shares of stock from stockholders on the market at the prevailing
price. Typically, repurchased stock is held as “treasury stock,” and the firm can reissue it in the future if
it desires. Diaz Manufacturing has spent a total of $23.3 million to repurchase the 571,320 shares of
common stock it currently holds as treasury stock. The company has had a policy of repurchasing
common stock, which has been subsequently reissued to senior executives under the firm's stock-option
plan.
treasury stock
stock that the firm has repurchased from investors
You may wonder why a firm's management would repurchase its own stock. This is a classic finance
question, and it has no simple answer. The conventional wisdom is that when a company has excess
cash and management believes its stock price is undervalued, it makes sense to purchase stock with the
cash.
Preferred Stock
Preferred stock is a cross between common stock and long-term debt. Preferred stock pays dividends at
a specified fixed rate, which means that the firm cannot increase or decrease the dividend rate,
regardless of whether the firm's earnings increase or decrease. However, like common stock dividends,
preferred stock dividends are declared by the board of directors, and in the event of financial distress,
the board can elect not to pay a preferred stock dividend. If preferred stock dividends are missed, the
firm is typically required to pay dividends that have been skipped in the past before they can pay
dividends to common stockholders. In the event of bankruptcy, preferred stockholders are paid before
common stockholders but after bondholders and other creditors. As shown in Exhibit 3.1
, Diaz
Manufacturing has no preferred stock outstanding, but the company is authorized to issue up to 10
million shares of preferred stock.
> BEFORE YOU GO ON
1.
What is net working capital? Why might a low value for this number be considered undesirable?
13
2.
Explain the accounting concept behind depreciation.
3.
What is treasury stock?
3.3 MARKET VALUE VERSUS BOOK VALUE
Although accounting statements are helpful to analysts and managers, they have a number of
limitations. One of these limitations, mentioned earlier, is that accounting statements are historical—
they are based on data such as the cost of a building that was built years ago. Thus, the value of assets
on the balance sheet is what the firm paid for them and not their current market value
—the amount
they are worth today.
market value
the price at which an item can be sold
Investors and management, however, care about how the company will do in the future. The best
information concerning how much a company's assets can earn in the future, as well as how much of a
burden its liabilities are, comes from the current market value of those assets and liabilities. Accounting
statements would therefore be more valuable if they measured current value. The process of recording
assets at their current market value is often called marking to market.
In theory, everyone agrees that it is better to base financial statements on current information.
Marking to market provides decision makers with financial statements that more closely reflect a
company's true financial condition; thus, they have a better chance of making the correct economic
decision, given the information available. For example, providing current market values means that
managers can no longer conceal a failing business or hide unrealized gains on assets.
For
some
perspective
on
mark-to-market
accounting,
go
to http://www.fool.com/investing/dividends-income/2008/10/02/mark-to-market-accounting-what-
you-should-know.aspx
.
On the downside, it can be difficult to identify the market value of an asset, particularly if there are
few transactions involving comparable assets. Critics also point out that estimating market value can
require complex financial modeling, and the resulting numbers can be open to manipulation and abuse.
Finally, mark-to-market accounting can become inaccurate if market prices deviate from the
“fundamental” values of assets and liabilities. This might occur because buyers and sellers have either
incorrect information, or have either over-optimistic or over-pessimistic expectations about the future.
A More Informative Balance Sheet
To illustrate why market value provides better economic information than book value, let's revisit the
balance sheet components discussed earlier. Our discussion will also help you understand why there can
be such large differences between some book-value and market-value balance sheet accounts.
14
Assets
For current assets, market value and book value may be reasonably close. The reason is that current
assets have a short life cycle and typically are converted into cash quickly. Then, as new current assets
are added to the balance sheet, they are entered at their current market price.
In contrast, long-term assets, which are also referred to as fixed assets, have a long life cycle and their
market value and book value are not likely to be equal. In addition, if an asset is depreciable, the
amount of depreciation shown on the balance sheet does not necessarily reflect actual loss of economic
value. As a general rule, the longer the time that has passed since an asset was acquired, the more likely
it is that the current market value will differ from the book value.
For example, suppose a firm purchased land for a trucking depot in Atlanta, Georgia, 30 years ago for
$100,000. Today the land is nestled in an expensive suburban area and is worth around $5.5 million. The
difference between the book value of $100,000 and the market value is $5.4 million. In another
example, say an airline company decided to replace its aging fleet of aircraft with new fuel-efficient jets
in the late 1990s. Following the September 11, 2001, terrorist attack, airline travel declined dramatically;
and during 2003 nearly one-third of all commercial jets were “mothballed.” In 2003 the current market
value of the replacement commercial jets was about two-thirds their original cost. Why the decline?
Because the expected cash flows from owning a commercial aircraft had declined a great deal.
Liabilities
The market value of liabilities can also differ from their book value, though typically by smaller amounts
than is the case with assets. For liabilities, the balance sheet shows the amount of money that the
company has promised to pay. This figure is generally close to the actual market value for short-term
liabilities because of their relatively short maturities.
For long-term debt, however, book value and market value can differ substantially. The market value
of debt with fixed interest payments is affected by the level of interest rates in the economy. More
specifically, after long-term debt is issued, if the market rate of interest increases, the market value of
the debt will decline. Conversely, if interest rates decline, the value of the debt will increase. For
example, assume that a firm has $1 million of 20-year bonds outstanding. If the market rate of interest
increases from 5 to 8 percent, the price of the bonds will decline to around $700,000.
4
Thus, changes in
interest rates can have an important effect on the market values of long-term liabilities, such as
corporate bonds. Even if interest rates do not change, the market value of long-term liabilities can
change if the performance of the firm declines and the probability of default increases.
Stockholders' Equity
The book value of the firm's equity is one of the least informative items on the balance sheet. The book
value of equity, as suggested earlier, is simply a historical record. As a result, it says very little about the
current market value of the stockholders' stake in the firm.
15
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In contrast, on a balance sheet where both assets and liabilities are marked to market, the firm's
equity is more informative to management and investors.
The difference between the market values of
the assets and liabilities provides a better estimate of the market value of stockholders' equity than the
difference in the book values.
Intuitively, this makes sense because if you know the “true” market value
of the firm's assets and liabilities, the difference must equal the market value of the stockholders'
equity.
You should be aware, however, that the difference between the sum of the market values of the
individual assets and total liabilities will not give us an exact estimate of the market value of
stockholders' equity. The reason is that the true total value of a firm's assets depends on how these
assets are utilized. By utilizing the assets efficiently, management can make the total value greater than
the simple sum of parts. We will discuss this concept in more detail in Chapter 18
.
Finally, if you know the market value of the stockholders' equity and the number of shares of stock
outstanding, it is easy to compute the stock price. Specifically, the price of a share of stock is the market
value of the firm's stockholders' equity divided by the number of shares outstanding.
A Market-Value Balance Sheet
Let's look at an example of how a market-value balance sheet can differ from a book-value balance
sheet. Marvel Airline is a small regional carrier that has been serving the Northeast for five years. The
airline has a fleet of short-haul jet aircraft, most of which were purchased over the past two years. The
fleet has a book value of $600 million. Recently, the airline industry has suffered substantial losses in
revenue due to price competition, and most carriers are projecting operating losses for the foreseeable
future. As a result, the market value of Marvel's aircraft fleet is only $400 million. The book value of
Marvel's long-term debt is $300 million, which is near its current market value. The firm has 100 million
shares outstanding. Using these data, we can construct two balance sheets, one based on historical
book values and the other based on market values:
Based on the book-value balance sheet, the firm's financial condition looks fine; the book value of
Marvel's aircraft at $600 million is near what the firm paid, and the stockholders' equity account is $300
million. But when we look at the market-value balance sheet, a different story emerges. We
immediately see that the value of the aircraft has declined by $200 million and the stockholders' equity
has declined by $200 million!
16
Why the decline in stockholders' equity? Recall that in Chapter 1
we argued that the value of any
asset—stocks, bonds, or a firm—is determined by the future cash flows the asset will generate. At the
time the aircraft were purchased, it was expected that they would generate a certain amount of cash
flows over time. Now that hard times plague the industry, the cash flow expectations have been
lowered, and hence the decline in the value of stockholders' equity.
APPLICATION 3.1 LEARNING BY DOING
The Market-Value Balance Sheet
PROBLEM:
Grady Means and his four partners in Menlo Park Consulting (MPC) have developed a
revolutionary new continuous audit program that can monitor high-risk areas within a firm and identify
abnormalities so that corrective actions can be taken. The partners have spent about $300,000
developing the program. The firm's bookkeeper carries the audit program as an asset valued at cost,
which is $300,000. To launch the product, the four partners recently invested an additional $1 million,
and the money is currently in the firm's bank account. At a recent trade show, a number of accounting
and financial consulting firms tried to buy the new continuous product—the highest offer being $15
million. Assuming these are MPC's only assets and liabilities, prepare the firm's book-value and market-
value balance sheets and explain the difference between the two.
APPROACH:
The main differences between the two balance sheets will be the treatment of the
$300,000 already spent to develop the program and the $15 million offer. The book-value balance sheet
is a historical document, which means all assets are valued at what it cost to put them in service, while
the market-value balance sheet reflects the value of the assets if they were sold under current market
conditions. The differences between the two approaches can be considerable.
SOLUTION:
The two balance sheets are as follows:
The book-value balance sheet provides little useful information. The book value of the firm's total
assets is $1.3 million, which consists of cash in the bank and the cost of developing the audit program.
Since the firm has no debt, total assets must equal the book value of stockholders' equity. The market
17
value tells a dramatically different story. The market value of the audit program is estimated to be $15.0
million; thus, the market value of stockholders' equity is $16.0 million and not $1.3 million as reported in
the book-value balance sheet.
> BEFORE YOU GO ON
1.
What is the difference between book value and market value?
2.
What are some objections to the preparation of marked-to-market balance sheets?
3.4 THE INCOME STATEMENT AND THE STATEMENT OF RETAINED EARNINGS
In the previous sections, we examined a firm's balance sheet, which is like a financial snapshot of the
firm at a point in time. In contrast, the income statement illustrates the flow of operating activity and
tells us how profitable a firm was between two points in time.
The Income Statement
income statement
a financial statement that reports a firm's revenues, expenses, and profits or losses over a period of time
The
income statement
summarizes the revenues, expenses, and the profitability (or losses) of the firm
over some period of time, usually a month, a quarter, or a year. The basic equation for the income
statement can be expressed as follows:
Let's look more closely at each element in this equation.
Revenues
A firm's revenues (sales) arise from the products and services it creates through its business operations.
For manufacturing and merchandising companies, revenues come from the sale of merchandise. Service
companies, such as consulting firms, generate fees for the services they perform. Other kinds of
businesses earn revenues by charging interest or collecting rent. Regardless of how they earn revenues,
most firms either receive cash or create an account receivable for each transaction, which increases
their total assets.
Expenses
Expenses are the various costs that the firm incurs to generate revenues. Broadly speaking, expenses are
(1) the value of long-term assets consumed through business operations, such as depreciation expense;
and (2) the costs incurred in conducting business, such as labor, utilities, materials, and taxes.
18
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Net Income
earnings per share (EPS)
net income divided by the number of common shares outstanding
The firm's net income reflects its accomplishments (revenues) relative to its efforts (expenses) during a
time period. If revenues exceed expenses, the firm generates net income for the period. If expenses
exceed revenues, the firm has a net loss. Net income is often referred to as profits, as income, or simply
as the “bottom line,” since it is the last item on the income statement. Net income is often reported on a
per-share basis and is then called earnings per share (EPS)
, where EPS equals net income divided by the
number of common shares outstanding. A firm's earnings per share tell a stockholder how much the
firm has earned (or lost) for each share of stock outstanding.
EXHIBIT 3.2 Diaz Manufacturing Income Statements for the Fiscal Year Ending December 31 ($
millions)
The income statement shows the sales, expenses, and profits earned by the firm over a specific period
of time.
a
Net sales is defined as total sales less all sales discounts and sales returns and allowances.
Income statements for Diaz Manufacturing for 2010 and 2011 are shown in Exhibit 3.2
. You can see
that in 2011 total revenues from all sources (net sales) were $1,563.7 million. Total expenses for
producing and selling those goods were $1,445.2 million—the total of the amounts for cost of goods
sold, selling and administrative expenses, depreciation, interest expense, and taxes.
5
19
Using Equation 3.3, we can use these numbers to calculate Diaz Manufacturing's net income for the
year:
Since Diaz Manufacturing had 54,566,054 common shares outstanding at year's end, its EPS was $2.17
per share ($118.5 million/54.566 million shares = $2.17 per share).
A Closer Look at Some Expense Categories
Next, we take a closer look at some of the expense items on the income statement. We discussed
depreciation earlier in relation to the balance sheet, and we now look at the role of depreciation in the
income statement.
Depreciation Expense.
An interesting feature of financial reporting is that companies are allowed to
prepare two sets of financial statements: one for tax purposes and one for managing the company and
for financial reporting to the SEC and investors. For tax purposes, most firms elect to accelerate
depreciation as quickly as is permitted under the tax code. The reason is that accelerated depreciation
results in a higher depreciation expense to the income statement, which in turn results in a lower
earnings before taxes (EBT) and a lower tax liability in the first few years after the asset is acquired. The
good news about accelerating depreciation for tax purposes is that the firm pays lower taxes but the
depreciation expense does not represent a cash flow. The depreciation method does not affect the cost
of the asset. In contrast, straight-line depreciation results in lower depreciation expenses to the income
statement, which results in higher EBT and higher tax payments. Firms generally use straight-line
depreciation in the financial statements they report to the SEC and investors because it makes their
earnings look better. The higher a firm's EBT, the higher its net income.
It is important to understand that the company does not take more total depreciation under
accelerated depreciation methods than under the straight-line method; the total amount of
depreciation expensed to the income statement over the life of an asset is the same. Total depreciation
cannot exceed the price paid for the asset. Accelerating depreciation only alters the timing of when the
depreciation is expensed.
Amortization Expense.
Amortization is the process of writing off expenses for intangible assets—such as
patents, licenses, copyrights, and trademarks—over their useful life. Since depreciation and
amortization are very similar, they are often lumped together on the income statement. Both are
noncash expenses, which means that an expense is recorded on the income statement, but the
associated cash does not necessarily leave the firm in that period
. For Diaz Manufacturing, the
depreciation and amortization expense for 2011 was $83.1 million.
At one time, goodwill was one of the intangible assets subject to amortization. As of June 2001,
however, goodwill could no longer be amortized. The value of the goodwill on a firm's balance sheet is
now subject to an annual impairment test.
This test requires that the company annually value the
businesses that were acquired in the past to see if the value of the goodwill associated with those
20
businesses has declined below the value at which it is being carried on the balance sheet. If the value of
the goodwill has declined (been impaired), management must expense the amount of the impairment.
This expense reduces the firm's reported net income.
Extraordinary Items.
Other items reported separately in the income statement are extraordinary items,
which are reserved for nonoperating gains or losses. Extraordinary items are unusual and infrequent
occurrences, such as gains or losses from floods, fires, or earthquakes. For example, in 1980 the volcano
Mount St. Helens erupted in Washington state, and Weyerhaeuser Company reported an extraordinary
loss of $67 million to cover the damage to its standing timber, buildings, and equipment. Diaz
Manufacturing has no extraordinary expense item during 2011.
Step by Step to the Bottom Line
You probably noticed in Exhibit 3.2
that Diaz Manufacturing's income statement showed income at
several intermediate steps before reaching net income, the so-called bottom line. These intermediate
income figures, which are typically included on a firm's income statement, provide important
information about the firm's performance and help identify what factors are driving the firm's income or
losses.
EBITDA.
The first intermediate income figure is EBITDA, or earnings before interest, taxes, depreciation,
and amortization. The importance of EBITDA is that it shows what is earned purely from operations and
reflects how efficiently the firm can manufacture and sell its products without taking into account the
cost of the productive asset base (plant and equipment and intangible assets). For Diaz Manufacturing,
EBITDA was $251.5 million in 2011.
EBIT.
Subtracting depreciation and amortization from EBITDA yields the next intermediate figure, EBIT,
or earnings before interest and taxes. EBIT for Diaz Manufacturing was $168.4 million.
EBT.
When interest expense is subtracted from EBIT, the result is EBT, or earnings before taxes. Diaz
Manufacturing had EBT of $162.8 million in 2011.
Net Income.
Finally, taxes are subtracted from EBT to arrive at net income. For Diaz Manufacturing, as
we have already seen, net income in 2011 was $118.5 million.
In Chapter 4
you will see how to use these intermediate income figures to evaluate the firm's financial
condition. Next, we look at the statement of retained earnings, which provides detailed information
about how management allocated the $118.5 million of net income earned during the period.
EXHIBIT 3.3 Diaz Manufacturing Statement of Retained Earnings for the Fiscal Year Ending December
31, 2011 ($ millions)
The statement of retained earnings accompanies the balance sheet and shows the beginning balance of
retained earnings, the adjustments made to retained earnings during the year, and the ending balance.
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Balance of retained earnings, December 31, 2010
$ (50.7)
Add: Net income, 2011
118.5
Less: Dividends to common stockholders
—
Balance of retained earnings, December 31, 2011
$ 67.8
The Statement of Retained Earnings
Corporations often prepare a statement of retained earnings, which identifies the changes in the
retained earnings account from one accounting period to the next. During any accounting period, two
events can affect the retained earnings account balance:
1.
When the firm reports net income or loss
2.
When the board of directors declares and pays a cash dividend
Exhibit 3.3
shows the activity in the retained earnings account for 2011 for Diaz Manufacturing. The
beginning balance is a negative $50.7 million. The firm's annual report explains that the retained
earnings deficit resulted from a $441 million write-down of assets that occurred when Diaz
Manufacturing became a stand-alone business in June 2003. As reported in the 2011 income statement
(
Exhibit 3.2
), the firm earned $118.5 million that year, and the board of directors elected not to declare
any dividends. Retained earnings consequently went from a negative $50.7 million to a positive balance
of $67.8 million, an increase of $118.5 million.
> BEFORE YOU GO ON
1.
How do you compute net income?
2.
What is EBITDA, and what does it measure?
3.
What accounting events trigger changes to the retained earnings account?
3.5 THE STATEMENT OF CASH FLOWS
There are times when the financial manager wants to know the details of all the cash inflows and
outflows that have taken place during the year and to reconcile the beginning-of-year and end-of-year
cash balances. The reason for the focus on cash flows is very practical. Managers must have a complete
understanding of the uses of cash and the sources of cash in the firm. Firms must have the cash to pay
wages, suppliers, and other creditors, and they often elect to defer cash receipts from sales by providing
credit to customers. Managers may also decide to issue new securities to raise cash, or may retire
existing liabilities or repurchase equity to use cash. Finally, the purchase and sale of long-term
productive assets can have a measurable impact on a firm's cash position. In sum, managers are
responsible for a wide variety of transactions that involve sources and uses of cash over an accounting
period. The statement of cash flows provides them with what amounts to an inventory of these
transactions, and helps them understand why the cash balance changed as it did from the beginning to
the end of the period.
22
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Sources and Uses of Cash
The statement of cash flows
shows the company's cash inflows (receipts) and cash outflows (payments
and investments) for a period of time. We derive these cash flows by looking at the firm's net income
during the period and at changes in balance sheet accounts from the beginning of the period (end of the
previous period) to the end of the period. In analyzing the statement of cash flows, it is important to
understand that changes in the balance sheet accounts reflect cash flows. More specifically, increases in
assets or decreases in liabilities and equity are uses of cash, while decreases in assets or increases in
liabilities and equity are sources of cash. These changes in balance sheet items can be summarized by
the following:
statement of cash flows
a financial statement that shows a firm's cash receipts and cash payments and investments for a period
of time
Working capital.
An increase in current assets (such as accounts receivable and inventory) is a use of cash. For example, if a firm increases its inventory, it must use cash to purchase the additional inventory. Conversely, the sale of inventory increases a firm's cash position. An increase in current liabilities (such as accounts or notes payable) is a source of cash. For example, if during the year a firm increases its accounts payable, it has effectively “borrowed” money from suppliers and increased its cash position.
Fixed assets.
An increase in long-term fixed assets is a use of cash. If a company purchases fixed assets during the year, it decreases cash because it must use cash to pay for the purchase. If the firm sells a fixed asset during the year, the firm's cash position will increase.
Long-term liabilities and equity.
An increase in long-term debt (bonds and private placement
debt) or equity (common and preferred stock) is a source of cash. The retirement of debt or the purchase of treasury stock requires the firm to pay out cash, reducing cash balances.
Dividends.
Any cash dividend payment decreases a firm's cash balance.
Organization of the Statement of Cash Flows
The statement of cash flows is organized around three business activities—operating activities, long-
term investing activities, and financing activities—and the reconciliation of the cash account. We discuss
each element next and illustrate them with reference to the statement of cash flows for Diaz
Manufacturing, which is shown in Exhibit 3.4
.
Operating Activities.
Cash flows from operating activities in the statement of cash flows are the net cash
flows that are related to a firm's principal business activities. The most important items are the firm's
net income, depreciation and amortization expense, and working capital accounts (other than cash and
short-term debt obligations, which are classified elsewhere).
EXHIBIT 3.4 Diaz Manufacturing Statement of Cash Flows for the Fiscal Year Ending December 31, 2011
($ millions)
23
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The statement of cash flows shows the sources of the cash that has come into the firm during a period
of time and the ways in which this cash has been used.
Operating Activities
Net income
$ 118.5
Additions (sources of cash)
Depreciation and amortization
83.1
Increase in accounts payable
24.3
Decrease in other current assets
8.6
Increase in accrued income taxes
1.2
Subtractions (uses of cash)
Increase in accounts receivable
(37.4)
Increase in inventories
(51.1)
Net cash provided by operating activities
$ 147.2
Long-Term Investing Activities
Property, equipment, and other assets
$ (88.3)
Increase in goodwill and other assets
(38.4)
Net cash used in investing activities
$(126.7)
Financing Activities
Increase in long-term debt
$ 268.4
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Purchase of treasury stock
(23.3)
Increase in notes payable
6.3
Net cash provided by financing activities
$ 251.4
Cash Reconciliation
a
Net increase in cash and marketable securities
$ 271.9
Cash and securities at beginning of year
16.6
Cash and securities at end of year
$ 288.5
a
Cash includes investments in marketable securities.
In Exhibit 3.4
, the first section of the statement of cash flows for Diaz Manufacturing shows the cash
flow from operations. The section starts with the firm's net income of $118.5 million for the year ending
December 31, 2011. Depreciation expense ($83.1 million) is added because it is a noncash expense on
the income statement.
Next come changes in the firm's working capital accounts that affect operating activities. Note that
working capital accounts that involve financing (bank loans and notes payable) and cash reconciliation
(cash and marketable securities) will be classified separately. For Diaz, the working capital accounts that
are sources
of cash are: (1) increase in accounts payable of $24.3 million ($349.3 − $325.0 = $24.3), (2)
decrease in other current assets of $8.6 million ($29.9 − $21.3 = $8.6), and (3) increase in accrued
income taxes of $1.2 million ($18.0 − $16.8 = $1.2). Changes in working capital items that are uses
of
cash are: (1) increase in accounts receivable of $37.4 million ($306.2 − $268.8 = $37.4) and (2) increase
in inventory of $51.1 million ($423.8 − $372.7 = $51.1). The total cash provided to the firm from
operations is $147.2 million.
To clarify why changes in working capital accounts affect the statement of cash flows, let's look at
some of the changes. Diaz had a $37.4 million increase in accounts receivable, which is subtracted from
net income as a use of cash because the number represents sales that were included in the income
statement but for which no cash has been collected. Diaz provided financing for these sales to its
customers. Similarly, the $24.3 million increase in accounts payable represents a source of cash because
goods and services the company purchased have been received but no cash has been paid out.
Long-Term Investing Activities.
Cash flows from long-term investing activities relate to the buying and
selling of long-term assets. In Exhibit 3.4
, the second section shows the cash flows from long-term
investing activities. Diaz Manufacturing made long-term investments in two areas, which resulted in a
cash outflow of $126.7 million. They were as follows: (1) the purchase of plant and equipment, totaling
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$88.3 million ($911.6 − $823.3 = $88.3) and (2) an increase in goodwill and other assets of $38.4 million
($450.0 − $411.6 = $38.4). Diaz's investments in property, equipment, and other assets resulted in a
cash outflow of $126.7 million.
Financing Activities.
Cash flows from financing occur when cash is obtained from or repaid to creditors
or owners (stockholders). Typical financing activities involve cash received from the issuance of common
or preferred stock, as well as cash from bank loans, notes payable, and long-term debt. Cash payments
of dividends to stockholders and cash purchases of treasury stock reduce a company's cash position.
Diaz Manufacturing's financing activities include the sale of bonds for $268.4 million ($574.0 − $305.6
= $268.4), which is a source of cash and the purchase of treasury stock for $23.3 million, which is a use
of cash. The firm's notes payable position was also increased by $6.3 million ($10.5 − $4.2 = $6.3).
Overall, Diaz had a net cash inflow from financing activities of $251.4 million.
Cash Reconciliation.
The final part of the statement of cash flows is a reconciliation of the firm's
beginning and ending cash positions. For Diaz Manufacturing, these cash positions are shown on the
2010 and 2011 balance sheets. The first step in reconciling the company's beginning and ending cash
positions is to add together the amounts from the first three sections of the statement of cash flows: (1)
the net cash inflows from operations of $147.2 million, (2) the net cash outflow from long-term
investment activities of −$126.7 million, (3) and the net cash inflow from financing activities of $251.4
million. Together, these three items represent a total net increase in cash to the firm of $271.9 million
($147.2 − $126.7 + $251.4 = $271.9). Finally, we add this amount ($271.9 million) to the beginning cash
balance of $16.6 million to obtain the ending cash balance for 2011 of $288.5 million ($271.9 + $16.6 =
$288.5).
> BEFORE YOU GO ON
1.
How do increases in fixed assets from one period to the next affect cash holdings for the firm?
2.
Name two working capital accounts that represent sources of cash for the firm.
3.
Explain the difference between cash flows from financing and investment activities.
3.6 TYING THE FINANCIAL STATEMENTS TOGETHER
Up to this point, we have treated a firm's financial statements as if they were independent of one
another. As you might suspect, though, the four financial statements presented in this chapter are
related. Let's see how.
Recall that the balance sheet summarizes what assets the firm has at a particular point in time and
how the firm has financed those assets with debt and equity. From one year to the next, the firm's
balance sheet will change because the firm will buy or sell assets and the dollar value of the debt and
equity financing will change. These changes are exactly the ones presented in the statement of cash
flows. In other words, the statement of cash flows presents a summary of the changes in a firm's
balance sheet from the beginning of a period to the end of that period.
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This concept is illustrated in Exhibit 3.5
, which presents summaries of the four financial statements
for Diaz Manufacturing for the year 2011. The exhibit also presents the balance sheet for the beginning
of that year, which is dated December 31, 2010. If you compare the changes in the balance sheet
numbers from the beginning of the year to the end of the year, you can see that these changes are in
fact summarized in the statement of cash flows. For example, the change in the cash balance of $271.9
million ($288.5 − $16.6 = $271.9) appears at the bottom of the statement of cash flows. Similarly,
excluding cash and notes payable, the change in net working capital from the beginning to the end of
2011 is $54.4 million, which is calculated as follows: [($751.3 − $367.3) − ($671.4 − $341.8)] = ($384.0 −
$329.6) = $54.4.
6
This number is equal to the net working capital investment reflected in the statement
of cash flows. Note, too, that the net working capital investment in Diaz's statement of cash flows is just
the total change in the firm's investment in the following working capital accounts: accounts payable,
other current assets, accrued income taxes, accounts receivable, and inventories. You can also see
in Exhibit 3.5
that the change in fixed assets, which includes net property plant and equipment,
goodwill, and other long-term assets, is $43.6 million ($849.4 − $805.8 = $43.6). This number is equal to
the sum of the cash flows from investing activities and depreciation and amortization, −$126.7 + $83.1 =
$43.6, in the statement of cash flows. We add depreciation to investing activities in the latter calculation
because the fixed asset accounts in the balance sheet are net of depreciation.
EXHIBIT 3.5 The Interrelations among the Financial Statements: Illustrated Using Diaz Manufacturing
Financial Results ($ millions)
The statement of cash flows ties together the income statement with the balance sheets from the
beginning and the end of the period. The statement of retained earnings shows how the retained
earnings account has changed from the beginning to the end of the period.
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Turning to the liability and equity side of the balance sheet, notice the change in the amount of debt
plus equity that the firm has sold in 2011, which is represented by the sum of the long-term liabilities
and notes and capital stock in the balance sheet. This sum equals the value of the financing activities in
the statement of cash flows. The change in the balance sheet values is calculated as follows: [($584.5 +
$869.6) − ($309.8 + $892.9)] = ($1,454.1 − $1,202.7) = $251.4 million.
7
Finally, since Diaz did not pay a
dividend in 2011, the change in retained earnings of $118.5 million [$67.8 − ($50.7) = $118.5] exactly
equals the company's net income, which appears on the top line of the statement of cash flows.
Again, the important point here is that the statement of cash flows summarizes the changes in the
balance sheet. How do the other financial statements fit into the picture? Well, the income statement
calculates the firm's net income, which is used to calculate the retained earnings at the end of the year
and is included as the first line in the statement of cash flows. The income statement provides an input
that is used in the balance sheet and the statement of cash flows. The statement of retained earnings
just summarizes the changes to the retained earnings account a little differently than the statement of
cash flows. This different format makes it simpler for managers and investors to see why retained
earnings changed as it did.
> BEFORE YOU GO ON
1.
Explain how the four financial statements are related.
3.7 CASH FLOWS TO INVESTORS
As we discussed in Chapter 1
, the concept of cash flow is very important in corporate finance. Financial
managers are concerned with maximizing the value of stockholders' shares, which means making
decisions that maximize the value of the cash flows that stockholders can expect to receive. Similarly,
the firm has interest and principal obligations to its debt holders that must be met. It is important to
recognize that the revenues, expenses, and net income reported in a firm's income statement provide
an incomplete picture of the cash flows available to its investors.
Net Income versus the Cash Flow to Investors
Managers and investors are primarily interested in a firm's ability to generate cash flows to meet the
firm's obligations to its debt holders and that can be distributed to stockholders; the
cash flow to
investors.
These cash obligations and distributions include interest payments and the repayment of
principal to the firm's debt holders, as well as distributions of cash to its stockholders in the form of
dividends or stock repurchases. Cash flow to investors is the cash flow that a firm generates for its
investors in a given period (cash receipts less cash payments and investments), excluding cash inflows
from investors themselves, such as from the sale of new equity or long-term interest-bearing debt.
cash flow to investors
the cash flow that a firm generates for its investors in a given period, excluding cash inflows from the
sale of securities to investors
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So how is cash flow to investors different from net income? One significant difference arises because
accountants do not necessarily count the cash coming into the firm and the cash going out when they
prepare financial statements. Under GAAP, accountants recognize revenue at the time a sale is
substantially completed, not when the customer actually pays the firm. In addition, because of the
matching principle, accountants match revenues with the costs of producing those revenues regardless
of whether these are cash costs to the firm during that period.
8
Finally, cash flows for capital
expenditures occur at the time that an asset is purchased, not when it is expensed through depreciation
and amortization. As a result of these accounting rules, there can be a noticeable difference between
the time when revenues and expenses are recorded and when cash is actually collected (in the case of
revenue) or paid (in the case of expenses).
Cash flow to investors is one of the most important concepts in finance as it identifies the cash flow in
a given period that is available to meet the firm's obligations to its debt holders and that can be
distributed to its stockholders. This, in turn, defines the value of their investments in the firm. The cash
flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow
invested in net working capital, minus the cash flow invested in long-term assets.
Cash Flow to Investors From Operating Activity
Accounting profits can be converted into cash flow to investors from operating activity by subtracting
the taxes that the firm paid during the period from earnings before interest and taxes (EBIT) and adding
back all of the firm's noncash expenses. This calculation results in a number that is different from the net
cash provided by operating activities that is reported in the statement of cash flows because it does not
include cash flows associated with working capital accounts. Unlike the statement of cash flows, when
we calculate cash flow to investors, we compute cash flows associated with net working capital
separately. We also start from EBIT since interest paid to debt holders has been deducted in the net
income calculation and we want to include it in cash flow to investors. Cash flow to investors from
operating activity (CFOA) can be formally written as:
For most businesses, the largest noncash expenses are depreciation and amortization of long-term
assets. These are noncash expenses because they are deducted from revenues on the income statement
during the years after a long-term asset was purchased, even though no cash is actually being paid out.
The cash outflow took place when the asset was purchased. Other noncash items include the following:
Depletion charges, which are like depreciation but apply to extractive natural resources, such as crude oil, natural gas, timber, and mineral deposits (noncash expense).
Deferred taxes, which are the portion of a firm's income tax expense that is postponed because of differences in the accounting policies adopted for financial reporting and for tax reporting (noncash expense).
Expenses that were paid in cash in a previous period (prepaid expenses), such as for rent and insurance (noncash expense).
Revenues previously received as cash but not yet earned (deferred revenues). An example of deferred revenue would be prepaid magazine subscriptions to a publishing company that are recorded as revenue in a period after the cash has been paid (noncash revenue).
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We can use the data from Diaz Manufacturing's 2011 income statement in Exhibit 3.2
to illustrate the
calculation of CFOA. If the company had no deferred taxes and the taxes reported in the income
statement equal the taxes actually paid by the firm, Diaz's CFOA in 2011 was:
Cash Flow Invested in Net Working Capital
As we discussed in Section 3.5, changes in current assets and liabilities from one period to the next
represent uses and sources of cash. When we calculate the cash flow to investors we account for these
sources and uses by computing the change in net working capital during the period. This change takes
into account all the money that has been invested in current assets, including cash and marketable
securities, accounts receivable and inventories, and all of the financing that has been received from
current liabilities, such as accounts payable and notes payable, during the period. These sources and
uses all directly affect the cash flow that is available to investors during the period.
Recall from Equation 3.2 that a firm's investment in net working capital (NWC) at any point in time
can be computed as the difference between its total current assets and total current liabilities:
We saw earlier that Diaz Manufacturing's investment in NWC at the end of 2011 was:
The corresponding value at the end of 2010 was:
As is the case with all balance sheet items, the investment in NWC is a snapshot at a point in time. To
determine the flow of cash into, or out of, working capital we compute the cash flow invested in net
working capital (CFNWC). This equals the difference between NWC at the end of the current period and
NWC at the end of the previous period:
For Diaz Manufacturing, CFNWC is:
The positive difference between Diaz Manufacturing's net working capital in 2011 and 2010 indicates
that current assets increased by $320.0 million more than current liabilities during 2011. This net
investment in NWC reduced the amount of cash that might otherwise have been available for
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distribution to the Diaz investors in 2011. Of course, investments in NWC are likely to yield positive cash
flows in the future. For example, accounts receivables can be collected, and inventories will eventually
be sold. Also, selling items on credit, or having a greater stock of finished inventories can help the
company attract new customers. For Diaz Manufacturing, the single largest investment in working
capital is the addition of $271.9 million to cash and marketable securities. We will discuss reasons why
firms make investments in cash in Chapter 14
.
Cash Flow Invested in Long-Term Assets
Long-term assets, such as land, buildings, and plant and equipment, represent a large portion of the
total assets of many firms. Because the purchases and sales of such assets can have a substantial impact
on the cash flow to investors, it is very important that we account for them in our cash flow calculations.
If a firm is a net investor (buys more than it sells) in long-term assets during a given year, its cash flow to
investors will be reduced by the amount of the net purchases. If the firm is a net seller of long-term
assets, its cash flow to investors will increase by the value of the net sales.
As we discussed earlier, Diaz Manufacturing had $911.6 million invested in plant and equipment and
$450.0 million invested in goodwill and other assets at the end of 2011 (
Exhibit 3.1
). The company's total
investment in long-term assets at the end of 2011 was therefore $911.6 million $450.0 million $1,361.6
million. The corresponding value at the end of 2010 was $823.3 million $411.6 million = $1,234.9 million.
As with investments in net working capital, we use the change in the value of the long-term assets to
compute the amount that a firm invested in long-term investments during a period. Specifically, the cash
flow invested in long-term assets (CFLTA) is computed as:
It is very important to remember that since depreciation is a noncash charge, we ignore accumulated
depreciation when we compute the effects of investment in long-term assets on cash flow to investors.
For Diaz Manufacturing, CFLTA in 2011 was:
where the $1,361.6 million and $1,234.9 million values represent the long-term asset values before
accumulated depreciation. This calculation indicates that Diaz Manufacturing invested a total of $126.7
million in long-term assets during 2011. Of this total, $88.3 million ($911.6 − $823.3 = $88.3) was
invested in plant and equipment and $38.4 million ($450 − $411.6 = $38.4) was invested in goodwill and
other assets. As with investment in net working capital, investments in long-term assets are likely to
generate positive cash flows in the future, but reduce the cash flow to investors in the current period.
Cash Flow To Investors: Putting It All Together
Having calculated the cash flow from operating activity, cash flow invested in net working capital, and
cash flow invested in long-term assets, we are now ready to compute cash flow to investors (CFI). We
use Equation 3.7 to do this:
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Note that in this calculation, CFNWC and CFLTA are subtracted from CFOA because investments in both
net working capital and long-term assets reduce the cash flow available to investors. Of course, it is
possible for either or both of these figures to be negative in a given period. For example, CFLTA will be
negative if proceeds for the sale of long-term assets exceed total investments in these assets.
Putting this all together for Diaz Manufacturing, we can see that the company's CFI in 2011 was:
The negative value indicates that Diaz invested more cash than was produced by its operating activity
during 2011. This is not uncommon for a rapidly growing company like Diaz, which experienced a sales
increase of almost 13% from 2010 to 2011. Fast-growing firms often must invest more cash than they
generate. The difference is financed by selling stock to investors or by borrowing money. In such
situations, both the old and new investors are counting on the firm to produce cash flows in the future
that will compensate them for the investment that they are making now. A brief look at the liability side
of the Diaz balance sheet suggests that the negative cash flow to investors was funded largely by issuing
new long-term debt.
EXAMPLE 3.1 DECISION MAKING
Cash Flow to Investors from Operating Activity
SITUATION:
You are a financial manager at Bonivo Corporation and are preparing a report for senior
management. You have asked two analysts that work for you to compute cash flow to investors from
operating activity during the year that just ended. A short while later they come to your office and
report that they cannot agree on how to do the calculation.
The first analyst thinks it should be computed as:
The second analyst proposes that the calculation is:
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Which calculation should you use for your report to senior management?
DECISION:
You should use the calculation proposed by the second analyst. This is the correct calculation.
The calculation proposed by the first analyst is incorrect. The first analyst has computed the net cash
provided by operating activities as it is calculated in a statement of cash flows. This calculation does
account for the firm's noncash depreciation and amortization expenses, but unlike the calculation of
cash flow to investors from operating activity, it incorporates changes in the firm's working capital
accounts other than cash and marketable securities. The first analyst also started from net income
rather than EBIT. It is important to start from EBIT rather than net income when calculating cash flows
for investors because the interest payments to debt holders were not deducted when EBIT was
calculated.
Additional Cash Flow Calculations
This section has introduced calculations of the cash distributed to a firm's investors. We will return to
the topic of cash flows in Chapters 11
and 18
. In those chapters we will develop measures of cash flow
that will allow us to determine (1) the incremental cash flows necessary to estimate the value of a
capital project and (2) the cash flows necessary to estimate the value of a firm.
> BEFORE YOU GO ON
1.
How does the calculation of net income differ from the calculation of cash flow to investors from operating activity?
2.
All else equal, if a firm increases its accounts payable, what effect will this have on cash flow to investors?
3.
What does it mean when a firm's cash flow to investors is negative?
3.8 FEDERAL INCOME TAX
We conclude the chapter with a discussion of corporate income taxes. Taxes take a big bite out of the
income of most businesses and represent one of their largest cash outflows. For example, as shown in
the income statement for Diaz Manufacturing (
Exhibit 3.2
), the firm's earnings before interest and taxes
(EBIT) in 2011 amounted to $168.4 million, and its tax bill was $44.3 million, or 26.3 percent of EBIT
($44.3/$168.4 = 0.263, or 26.3 percent)—not a trivial amount by any standard. Because of their
magnitude, taxes play a critical role in most business financial decisions.
As you might suspect, corporations spend a considerable amount of effort and money deploying tax
specialists to find legal ways to minimize their tax burdens. The tax laws are complicated, continually
changing, and at times seemingly bizarre—in part because the tax code is not an economically rational
document, but reflects the political and social values of Congress and the President.
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EXHIBIT 3.6 Corporate Tax Rates for 2010
The federal corporate marginal tax rate varies from 15 to 39 percent. Generally speaking, smaller
companies with lower taxable income have lower tax rates than larger companies with higher taxable
incomes. Smaller businesses are given preferential treatment to encourage new business formation. (1)
(2) (3) (4)
If you work in the finance or accounting area, a tax specialist will advise you on the tax implications of
most decisions in which you will be involved as a businessperson. Consequently, we will not try to make
you a tax expert, but we will present a high-level view of the major portions of the federal tax code that
have a significant impact on business decision making.
Corporate Income Tax Rates
The U.S. Department of the Treasury provides a comprehensive tax information site
at http://www.irs.gov
.
Exhibit 3.6
shows the 2010 federal income tax schedule for corporations. As you can see, the marginal
tax rate varies from 15 percent to 39 percent (column 3). In general, companies with lower taxable
incomes have lower tax rates than larger companies with higher taxable incomes. Historically, the
federal income tax code has given preferential treatment to small businesses and start-up companies as
a means of stimulating new business formation. In addition, the federal system is a progressive income
tax system; that is, as the level of income rises, the tax rate rises. Under the current tax code, which has
its origins in the Tax Reform Act of 1986, marginal tax rates do not increase continuously through the
income brackets, however. As you can see in Exhibit 3.6
, marginal tax rates rise from 15 percent to 39
percent for incomes up to $335,000; they decrease to 34 percent, then increase to 38 percent for
incomes up to $18.3 million; and they ultimately rest at 35 percent for all taxable income above $18.3
million.
Average versus Marginal Tax Rates
The difference between the average tax rate and the marginal tax rate is an important consideration in
financial decision making. The average tax rate
is simply the total taxes paid divided by taxable income.
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In contrast, the marginal tax rate
is the tax rate that is paid on the last dollar of income earned. Exhibit
3.6
shows both the marginal tax rates and average tax rates for corporations.
average tax rate
total taxes paid divided by taxable income
marginal tax rate
the tax rate paid on the last dollar of income earned
A simple example will clarify the difference between the average and marginal tax rates. Suppose a
corporation has a taxable income of $150,000. Using the data in Exhibit 3.6
, we can determine the firm's
federal income tax bill, its marginal tax rate, and its average tax rate. The firm's total tax bill is computed
as follows:
The firm's average tax rate is equal to the total taxes divided by the firm's total taxable income; thus, the
average tax rate is $41,750/$150,000 = 0.278, or 27.8 percent. The firm's marginal tax rate is the rate
paid on the last dollar earned, which is 39 percent.
When you are making investment decisions for a firm, the relevant tax rate to use is usually the
marginal tax rate. The reason is that new investments (projects) are expected to generate new cash
flows, which will be taxed at the firm's marginal tax rate.
To simplify calculations throughout the book, we will generally specify a single tax rate for a
corporation, such as 40 percent. The rate may include some payment for state and local taxes, which
will make the total tax rate the firm pays greater than the federal rate.
APPLICATION 3.2 LEARNING BY DOING
The Difference between Average and Marginal Tax Rates
PROBLEM:
Taxland Corporation has taxable income of $90,000. What is the firm's federal corporate
income tax liability? What are the firm's average and marginal tax rates?
APPROACH:
Use Exhibit 3.6
to calculate the firm's tax bill. To calculate the average tax rate, divide the
total amount of taxes paid by the $90,000 of taxable income. The marginal tax rate is the tax rate paid
on the last dollar of taxable income.
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SOLUTION:
Unequal Treatment of Dividends and Interest Payments
An interesting anomaly in the tax code is the unequal treatment of interest and dividend payments. For
the most common type of corporation, interest paid on debt obligations is a tax-deductible business
expense. Dividends paid to common or preferred stockholders are not deductible, however.
The unequal treatment of interest and dividend payments is not without consequences. In effect, it
lowers the cost of debt financing compared with the cost of an equal amount of common or preferred
stock financing. Thus, there is a tax-induced bias toward the use of debt financing, which we discuss
more thoroughly in later chapters.
> BEFORE YOU GO ON
1.
Why is it important to consider the consequences of taxes when financing a new project?
2.
Which type of tax rate, marginal or average, should be used in analyzing the expansion of a product line, and why?
3.
What are the tax implications of a decision to finance a project using debt rather than new equity?
SUMMARY OF Learning Objectives
Discuss generally accepted accounting principles (GAAP) and their importance to the economy.
GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time.
The principles determine the rules for how a company maintains its accounting system and how it
prepares financial statements. Accounting standards are important because without them, each firm
could develop its own unique accounting practices, which would make it difficult for anyone to monitor
the firm's true performance or compare the performance of different firms. The result would be a loss of
confidence in the accounting system and the financial reports it produces. Fundamental accounting
principles include that transactions are arms-length, the cost principle, the realization principle, the
matching principle, and the going concern assumption.
Explain the balance sheet identity and why a balance sheet must balance.
A balance sheet provides a summary of a firm's financial position at a particular point in time. It
identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of
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funding from creditors (liabilities) and owners (stockholders' equity) that were used to buy the assets.
The balance sheet identity is: Total assets = Total liabilities + Total stockholders' equity. Stockholders'
equity represents ownership in the firm and is the residual claim of the owners after all other obligations
to creditors, employees, and vendors have been paid. The balance sheet must always balance because
the owners get what is left over after all creditors have been paid—that is Total stockholders' equity =
Total assets − Total liabilities.
Describe how market-value balance sheets differ from book-value balance sheets.
Book value is the amount a firm paid for its assets at the time of purchase. The current market value of
an asset is the amount that a firm would receive for the asset if it were sold on the open market (not in
a forced liquidation). Most managers and investors are more concerned about what a firm's assets can
earn in the future than about what the assets cost in the past. Thus, marked-to-market balance sheets
are more helpful in showing a company's true financial condition than balance sheets based on historical
costs. Of course, the problem with marked-to-market balance sheets is that it is difficult to estimate
market values for some assets and liabilities.
Identify the basic equation for the income statement and the information it provides.
An income statement presents a firm's profit or loss for a period of time, usually a month, quarter, or
year. The income statement identifies the major sources of revenues generated by the firm and the
corresponding expenses needed to generate those revenues. The equation for the income statement is
Net income = Revenues − Expenses. If revenues exceed expenses, the firm generates a net profit for the
period. If expenses exceed revenues, the firm generates a net loss. Net profit or income is the most
comprehensive accounting measure of a firm's performance.
Understand the calculation of cash flows from operating, investing, and financing activities
required in the statement of cash flows.
Cash flows from operating activities in the statement of cash flows are the net cash flows that are
related to a firm's principal business activities. The most important items are the firm's net income,
depreciation and amortization expense, and working capital accounts (other than cash and short-term
debt obligations, which are classified elsewhere). Cash flows from long-term investing activities relate to
the buying and selling of long-term assets. Cash flows from financing occur when cash is obtained from
or repaid to creditors or owners (stockholders). Typical financing activities involve cash received from
the issuance of common or preferred stock, as well as cash from bank loans, notes payable, and long-
term debt. Cash payments of dividends to stockholders and cash purchases of treasury stock reduce a
company's cash position.
Explain how the four major financial statements discussed in this chapter are related.
The four financial statements discussed in the chapter are the balance sheet, the income statement, the
statement of cash flows, and the statement of retained earnings. The key financial statement that ties
the other three statements together is the statement of cash flows, which summarizes changes in the
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balance sheet from the beginning of the year to the end. These changes reflect the information in the
income statement and in the statement of retained earnings.
Identify the cash flow to a firm's investors using its financial statements.
Cash flow to investors is the cash flow that a firm generates in a given period (cash receipts less cash
payments and investments), excluding cash inflows from new equity sales or long-term debt issues. Cash
flow to investors is the cash flow in a given period that is used to meet the firm's obligations to its debt
holders and that is distributed to its equity investors, which in turn defines the value of their
investments in the firm over time. The cash flow to investors is calculated as the cash flow to investors
from operating activity, minus the cash flow invested in net working capital, minus the cash flow
invested in long-term assets.
Discuss the difference between average and marginal tax rates.
The average tax rate is computed by dividing the total taxes by taxable income. It takes into account the
taxes paid at all levels of income and will normally be lower than the marginal tax rate, which is the rate
that is paid on the last dollar of income earned. However, for very high income earners, these two rates
can be equal. When companies are making financial investment decisions, they use the marginal tax rate
because new projects are expected to generate additional cash flows, which will be taxed at the firm's
marginal tax rate.
SUMMARY OF
Key Equations
Self-Study Problems
3.1
The going concern assumption
of GAAP implies that the firm:
a.
Is going under and needs to be liquidated at historical cost.
b.
Will continue to operate and its assets should be recorded at historical cost.
c.
Will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value.
d.
Is going under and needs to be liquidated at liquidation value.
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3.2
The Ellicott City Ice Cream Company management has just completed an assessment of the company's assets and liabilities and has obtained the following information. The firm has
total current assets worth $625,000 at book value and $519,000 at market value. In addition, its long-term assets include plant and equipment valued at market for $695,000, while their book value is $940,000. The company's total current liabilities are valued at market for $543,000, while their book value is $495,000. Both the book value and the market value of long-term debt is $350,000. If the company's total assets are equal to a market value of $1,214,000 (book value of $1,565,000), what are the book value and market
value of its stockholders' equity?
3.3
Depreciation and amortization expenses are:
a.
Part of current assets on the balance sheet.
b.
After-tax expenses that reduce a firm's cash flows.
c.
Long-term liabilities that reduce a firm's net worth.
d.
Noncash expenses that cause a firm's after-tax cash flows to exceed its net income.
3.4
You are given the following information about Clarkesville Plumbing Company. Revenues
last year totaled $896, depreciation expenses $75, costs of goods sold $365, and interest expenses $54. At the end of the year, current assets were $121 and current liabilities were $107. The company has an average tax rate of 34 percent. Calculate its net income by setting up an income statement.
3.5
The Huntington Rain Gear Company had $633,125 in taxable income in the year ending September 30, 2010. Calculate the company's tax using the tax schedule in Exhibit 3.6
.
Solutions to Self-Study Problems
3.1
One of the key assumptions under GAAP is the going concern assumption
, which states that the firm: c.
Will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value.
3.2
The book value and market value of stockholders' equity are shown below (in thousands of dollars):
3.3
Depreciation and amortization expenses are: d.
Noncash expenses that cause a firm's after-tax cash flows to exceed its net income.
3.4
Clarkesville's income statement and net income are as follows:
Clarkesville Plumbing Company Income Statement for the Fiscal Year Ending December 31, 2011
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Amount
Revenues
$ 896.00
Costs
365.00
EBITDA
$ 531.00
Depreciation
75.00
EBIT
$ 456.00
Interest
54.00
EBT
$ 402.00
Taxes (34%)
136.68
Net income
$ 265.32
3.5
Huntington's tax bill is calculated as follows:
Critical Thinking Questions
3.1
What is a major reason for the accounting scandals in recent years? How do firms sometimes attempt to meet Wall Street analysts' earnings projections?
3.2
Why are taxes and the tax code important for managerial decision making?
3.3
Identify the five fundamental principles of GAAP, and explain briefly their importance.
3.4
Explain why firms prefer to use accelerated depreciation methods over the straight-line method for tax purposes.
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3.5
What is treasury stock? Why do firms have treasury stock?
3.6
Define book-value accounting and market-value accounting.
3.7
Compare and contrast depreciation expense and amortization expense.
3.8
Why are retained earnings not considered an asset of the firm?
3.9
How does a firm's cash flow to investors from operating activity differ from net income, and why?
3.10
What is the statement of cash flows, and what is its role?
Questions and Problems
3.1 Balance sheet:
Given the following information about Elkridge Sporting Goods, Inc., construct a balance sheet for June 30, 2011. On that date the firm had cash and marketable securities of $25,135, accounts receivable of $43,758, inventory of $167,112, net fixed assets of $325,422, and other assets of $13,125. It had accounts payables of $67,855, notes payables of $36,454, long-term debt of $223,125, and common stock of $150,000. How much retained earnings did the firm have?
3.2 Inventory accounting:
Differentiate between FIFO and LIFO.
3.3 Inventory accounting:
Explain how the choice of FIFO versus LIFO can affect a firm's balance sheet and income statement.
3.4 Market-value accounting:
How does the use of market-value accounting help managers?
3.5 Working capital:
Laurel Electronics reported the following information at its annual meeting: The company had cash and marketable securities worth $1,235,455, accounts payables worth $4,159,357, inventory of $7,121,599, accounts receivables of $3,488,121, short-term notes payable worth $1,151,663, and other current assets of $121,455. What is the company's net working capital?
3.6 Working capital:
The financial information for Laurel Electronics referred to in Problem 3.5 is all at book value. Suppose marking to market reveals that the market value of the firm's inventory is 20 percent below its book value, its receivables are 25 percent below its book value, and the market value of its current liabilities is identical to the book value. What
is the firm's net working capital using market values? What is the percentage change in net working capital?
3.7 Income statement:
The Oakland Mills Company has disclosed the following financial information in its annual reports for the period ending March 31, 2011: sales of $1.45 million, costs of goods sold of $812,500, depreciation expenses of $175,000, and interest expenses of $89,575. Assume that the firm has a tax rate of 35 percent. What is the company's net income? Set up an income statement to answer the question.
3.8 Cash flows:
Describe the organization of the statement of cash flows.
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3.9 Cash flows:
During 2011 Towson Recording Company increased its investment in marketable securities by $36,845, funded fixed-assets acquisitions of $109,455, and had marketable securities of $14,215 mature. What is the net cash used in investing activities?
3.10 Cash flows:
Caustic Chemicals management identified the following cash flows as significant in their year end meeting with analysts: During the year Caustic repaid existing debt of $312,080 and raised additional debt capital of $650,000. It also repurchased stock in the open market for a total of $45,250. What is the net cash provided by financing activities?
3.11 Cash flows:
Identify and explain the noncash expenses that a firm may incur.
3.12 Cash flows:
Given the data for Oakland Mills Company in Problem 3.7, compute the cash flows to investors from operating activity.
3.13 Cash flows:
Hillman Corporation reported current assets of $3,495,055 on December 31, 2011 and current assets of $3,103,839 on December 31, 2010. Current liabilities for the firm were $2,867,225 and $2,760,124 at the end of 2011 and 2010, respectively. Compute the cash flow invested in net working capital at Hillman Corporation during 2011.
3.14 Cash flows:
Del Bridge Construction had long-term assets before depreciation of $990,560 on December 31, 2010 and $1,211,105 on December 31, 2011. How much cash flow was invested in long-term assets by Del Bridge during 2011?
3.15 Tax:
Define average tax rate and marginal tax rate.
3.16 Tax:
What is the relevant tax rate to use when making financial decisions? Explain why.
3.17 Tax:
Manz Property Management Company announced that in the year ended June 30, 2011, its earnings before taxes amounted to $1,478,936. Calculate its taxes using Exhibit 3.6
.
3.18 Balance sheet:
Tim Dye, the CFO of Blackwell Automotive, Inc., is putting together this year's financial statements. He has gathered the following balance sheet information: The firm
had a cash balance of $23,015, accounts payable of $163,257, common stock of $313,299, retained earnings of $512,159, inventory of $212,444, goodwill and other assets equal to $78,656, net plant and equipment of $711,256, and short-term notes payable of $21,115. It also had accounts receivable of $141,258 and other current assets of $11,223. How much long-term debt does Blackwell Automotive have?
3.19 Working capital:
Mukhopadhya Network Associates has a current ratio of 1.60, where the current ratio is defined as follows: current ratio = current assets/current liabilities. The firm's current assets are equal to $1,233,265, its accounts payables are $419,357, and its notes payables are $351,663. Its inventory is currently at $721,599. The company plans to raise funds in the short-term debt market and invest the entire amount in additional inventory. How much can notes payable increase without the current ratio falling below 1.50?
3.20 Market value:
Reservoir Bottling Company reported the following information at the end of the year. Total current assets are worth $237,513 at book value and $219,344 at market value. In addition, plant and equipment has a market value of $343,222 and a book value of $362,145. The company's total current liabilities are valued at market for $134,889 and have a book value of $129,175. Both the book value and the market value of long-term debt is $144,000. If the company's total assets have a market value of $562,566 and a book value of $599,658, what is the difference between the book value and market value of its stockholders' equity?
3.21 Income statement:
Nimitz Rental Company provided the following information to its auditors
. For the year ended March 31, 2011, the company had revenues of $878,412, general and administrative expenses of $352,666, depreciation expenses of $131,455, 42
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leasing expenses of $108,195, and interest expenses equal to $78,122. If the company's tax rate is 34 percent, what is its net income after taxes?
3.22 Income statement:
Sosa Corporation recently reported an EBITDA of $31.3 million and net income of $9.7 million. The company had $6.8 million in interest expense, and its corporate tax rate was 35 percent. What was its depreciation and amortization expense?
3.23 Income statement:
Fraser Corporation has announced that its net income for the year ended June 30, 2011 was $1,353,412. The company had EBITDA of $4,967,855 and its depreciation and amortization expense was equal to $1,112,685. The company's tax rate is 34 percent. What was its interest expense?
3.24 Income Statement:
For its most recent fiscal year, Carmichael Hobby Shop recorded EBITDA of $512,725.20, EBIT of $362,450.20, zero interest expense, and cash flow to investors from operating activity of $348,461.25. Assuming there are no non-cash revenues recorded on the income statement, what is the firm's net income after taxes?
3.25 Retained earnings:
Columbia Construction Company earned $451,888 during the year ended June 30, 2011. After paying out $225,794 in dividends, the balance went into retained
earnings. If the firm's total retained earnings were $846,972, what was the retained earnings on its balance sheet on July 1, 2010?
3.26 Cash flows:
Refer to the information given in Problem 3.21. What is the cash flow for Nimitz
Rental?
3.27 Tax:
Mount Hebron Electrical Company's financial statements indicated that the company had earnings before interest and taxes of $718,323. The interest rate on its $850,000 debt was 8.95 percent. Calculate the taxes the company is likely to owe. What are the marginal and average tax rates for this company?
3.28
The Centennial Chemical Corporation announced that, for the period ending March 31, 2011, it had earned income after taxes worth $5,330,275 on revenues of $13,144,680. The company's costs (excluding depreciation and amortization) amounted to 61 percent of sales and it had interest expenses of $392,168. What is the firm's depreciation and amortization expense if its tax rate is 34 percent?
3.29
Eau Claire Paper Mill, Inc., had, at the beginning of the current fiscal year, April 1, 2010,
retained earnings of $323,325. During the year ended March 31, 2011, the company produced net income after taxes of $713,445 and paid out 45 percent of its net income as dividends. Construct a statement of retained earnings and compute the year-end balance of retained earnings.
3.30
Menomonie Casino Company earned $23,458,933 before interest and taxes for the fiscal year ending March 31, 2011. If the casino had interest expenses of $1,645,123, calculate its tax burden using Exhibit 3.6
. What are the marginal and the average tax rates for this company?
3.31
Vanderheiden Hog Products Corp. provided the following financial information for the quarter ending June 30, 2011:
Net income: $189,425
Depreciation and amortization: $63,114
Increase in receivables: $62,154
Increase in inventory: $57,338
Increase in accounts payable: $37,655
Decrease in other current assets: $27,450
What is this firm's cash flow from operating activities during this quarter?
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3.32 Cash flows:
Analysts following the Tomkovick Golf Company were given the following balance sheet information for the years ended June 30, 2011 and June 30, 2010:
In addition, it was reported that the company had a net income of $3,155,848 and that
depreciation expenses were equal to $212,366 during 2011.
a.
Construct a 2011 cash flow statement for this firm.
b.
Calculate the net cash provided by operating activities for the statement of cash flows.
c.
What is the net cash used in investing activities?
d.
Compute the net cash provided by financing activities.
3.33 Cash flows:
Based on the financial statements for Tomkovick Golf Company above, compute the cash flow invested in net working capital and the cash flow invested in long-
term assets that you would use in a calculation of the cash flow to investors for 2011.
Sample Test Problems
3.1
The Drayton, Inc., balance sheet shows current assets of $256,312 and total assets of $861,889. It also shows current liabilities of $141,097, common equity of $200,000, and retained earnings of $133,667. How much long-term debt does the firm have?
3.2
Ellicott Testing Company produced revenues of $745,000 in 2011. It had expenses (excluding depreciation) of $312,640, depreciation of $65,000, and interest expense of $41,823. It has an average tax rate of 34 percent. What was the firm's net income after taxes in 2011?
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3.3
Tejada Enterprises reported EBITDA of $7,300,125 and net income of $3,328,950 for the fiscal year ended December 31, 2011. During the same period, the company had $1,155,378 in interest expense, $1,023,285 in depreciation and amortization expense, and an average corporate tax rate of 35 percent. What was the cash flow to investors from operating activity during 2011?
3.4
In the year ended June 30, 2011, Tri King Company increased its investment in marketable securities by $234,375, made fixed-assets acquisitions totaling $1,324,766, and sold $77,215 of long-term debt. In addition, the firm had a net inflow of $365,778 from selling assets. What is the net cash used in long-term investing activities?
3.5
Triumph Soccer Club has the following cash flows during this year: It repaid existing debt
of $875,430 while raising new debt capital of $1,213,455. It also repurchased stock in the open market for a total of $71,112. What is the net cash provided by financing activities?
1
Although Diaz Manufacturing Company is not a real firm, the financial statements and situations
presented are based on a composite of actual firms.
2
The terms owners' equity, stockholders' equity, shareholders' equity, net worth
, and equity
are used
interchangeably to refer to the ownership of a corporation's stock.
3
An identity
is an equation that is true by definition; thus, a balance sheet must balance.
4
We will discuss how changes in interest rates affect the market price of debt in Chapter 8
, so for now,
don't worry about the numerical calculation.
5
Looking at Exhibit 3.2
, we find that the total expenses (in millions) are as follows: $1,081.1 + $231.1 +
$83.1 + $5.6 + $44.3 = $1,445.2.
6
From the 2011 balance sheet: (1) current assets − cash = $1,039.8 − $288.5 = $751.3, and (2) current
liabilities − notes payable = $377.8 − $10.5 = $367.3. The calculations are similar for the 2010 balance
sheet.
7
From the 2011 balance sheet, note the following: debt $574.0 (long-term debt) $10.5 (notes payable)
$584.5 and equity $50.0 (common stock) $842.9 (additional paid-in capital) $23.3 (treasury stock)
$869.6. The calculations for 2010 are made in a similar manner.
8
The accounting practice of recognizing revenues and expenses as they are earned and incurred, and
not when cash is received or paid, is called accrual accounting.
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Topics
Start Learning
What's New
3: Financial Statements, Cash Flows, and Taxes
4: Analyzing Financial Statements
5: The Time Value of Money
36h 16m remaining
4
Analyzing Financial Statements
Scott Olson/Getty Images, Inc. (top); Rick Wilking/Reuters/©Corbis (bottom)
Learning Objectives
Explain the three perspectives from which financial statements can be viewed.
Describe common-size financial statements, explain why they are used, and be able to prepare and
use them to analyze the historical performance of a firm.
Discuss how financial ratios facilitate financial analysis and be able to compute and use them to
analyze a firm's performance.
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Describe the DuPont system of analysis and be able to use it to evaluate a firm's performance and
identify corrective actions that may be necessary.
Explain what benchmarks are, describe how they are prepared, and discuss why they are important
in financial statement analysis.
Identify the major limitations in using financial statement analysis.
The last three decades witnessed a major shift in the U.S. retailing market place. By taking advantage of
logistic and purchasing advantages, large-scale discount chains have been able to reduce their costs and
lower prices for consumers, fueling the explosive expansion of retailers such as the Target and Wal-Mart
Stores. Competition for customers between these firms is intense, with Target pursuing a strategy
reliant on consumer discretionary purchases, and Wal-Mart focused on very low prices for consumer
basics.
Just how do analysts compare the performance of companies like Target and Wal-Mart? One
approach is to compare accounting data from the financial statements that companies file with the SEC.
Below are data for total sales and net income for Target (TGT) and Wal-Mart (WMT) for the fiscal year
ending January 2010:
The accounting numbers by themselves are not very revealing. Wal-Mart is a much larger firm than
Target, with greater sales and net income. This difference in size makes it difficult to assess the actual
performance differences between the two firms. However, if we compute one of the profit-ability ratios
discussed in this chapter, the net profit margin, we can identify more clearly the performance difference
between the two retailers. The net profit margins (net income/total sales) for Target and Wal-Mart are
3.81 percent and 3.54 percent, respectively. This means that for every $100 in revenues, TGT is able to
generate $3.81 in profit, whereas WMT generates only $3.54. As this example illustrates, one advantage
of using ratios is that they make direct comparisons of companies possible by adjusting for size
differences.
This chapter discusses financial ratio analysis (or financial statement analysis), which involves the
calculation and comparison of ratios derived from financial statements. These ratios can be used to
draw useful conclusions about a company's financial condition, its operating efficiency, and the
attractiveness of its securities as investments.
CHAPTER PREVIEW
In Chapter 3
we reviewed the basic structure of financial statements. This chapter explains how financial
statements are used to evaluate a company's overall performance and assess its strengths and
shortcomings. The basic tool used to do this is financial ratio analysis. Financial ratios are computed by
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dividing one number from a firm's financial statements by another such number in order to allow for
meaningful comparisons between firms or areas within a firm.
Management can use the information from this type of analysis to help maximize the firm's value by
identifying areas where performance improvements are needed. For example, the analysis of data from
financial statements can help determine why a firm's cash flows are increasing or decreasing, why a
firm's profitability is changing, and whether a firm will be able to pay its bills next month.
We begin the chapter by discussing some general guidelines for financial statement analysis, along with
three different perspectives on financial analysis: those of the stockholder, manager, and creditor. Next,
we describe how to prepare common-size financial statements, which allow us to compare firms that
differ in size and to analyze a firm's financial performance over time. We then explain how to calculate
and interpret key financial ratios and discuss the DuPont system, a diagnostic tool that uses financial
ratios. After a discussion of benchmarks, we conclude with a description of the limitations of financial
statement analysis.
4.1 BACKGROUND FOR FINANCIAL STATEMENT ANALYSIS
financial statement analysis
the use of financial statements to evaluate a company's overall performance and assess its strengths
and shortcomings
This chapter will guide you through a typical financial statement analysis
, which involves the use of
financial ratios to analyze a firm's performance. First, we look at the different perspectives we can take
when analyzing financial statements; then we present some helpful guidelines for financial statement
analysis.
Perspectives on Financial Statement Analysis
Stockholders and stakeholders may differ in the information they want to gain when analyzing financial
statements. In this section, we discuss three perspectives from which we can view financial statement
analysis: those of (1) stockholders, (2) managers, and (3) creditors. Although members of each of these
groups interpret financial statements from their own point of view, the perspectives are not mutually
exclusive.
Stockholders' Perspective
Stockholders are primarily concerned with the value of their stock and with how much cash they can
expect to receive from dividends and capital appreciation over time. Therefore, stockholders want
financial statements to tell them how profitable the firm is, what the return on their investment is, and
how much cash is available for stockholders, both in total and on a per-share basis. Ultimately,
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stockholders are interested in how much a share of stock is worth. We address pricing issues in detail
in Chapter 9
, but financial analysis is a key step in valuing a company's stock.
Managers' Perspective
Broadly speaking, management's perspective of financial statement analysis is similar to that of
stockholders. The reason is that stockholders own the firm and managers have a fiduciary responsibility
to make decisions that are in the owners' best interests. Thus, managers are interested in the same
performance measures as stockholders: profitability, how much cash is available for stockholders,
capital appreciation, return on investment, and the like.
Managers, however, are also responsible for running the business on a daily basis and must make
decisions that will maximize stockholder wealth in the long run. Maximizing stockholder wealth does not
involve a single big decision, but rather a series of smaller day-to-day decisions. Thus, managers need
feedback on the short-term impact these day-to-day decisions have on the firm's financial statements
and its current stock price. For example, managers can track trends in sales and can determine how well
they are controlling expenses and how much of each sales dollar goes to the bottom line. In addition,
managers can see the impact of their investment, financing, and working capital decisions reflected in
the financial statements. Keep in mind that managers, as insiders, have access to much more detailed
financial information than those outside the firm. Generally, outsiders have access to only published
financial statements for publicly traded firms.
Creditors' Perspective
The primary concern of creditors is whether and when they will receive the interest payments they are
entitled to and when they will be repaid the money they loaned to the firm. Thus, a firm's creditors,
including long-term bondholders, closely monitor how much debt the firm is currently using, whether
the firm is generating enough cash to pay its day-to-day bills, and whether the firm will have sufficient
cash in the future to make interest and principal payments on long-term debt after
satisfying obligations
that have a higher legal priority, such as paying employees' wages. Of course, the firm's ability to pay
ultimately depends on cash flows and profitability; hence, creditors—like stockholders and managers—
are interested in those aspects of the firm's financial performance.
Guidelines for Financial Statement Analysis
We turn now to some general guidelines that will help you when analyzing a firm's financial statements.
First, make sure you understand which perspective you are adopting to conduct your analysis:
stockholder, manager, or creditor. The perspective will dictate the type of information you need for the
analysis and may affect the actions you take based on the results.
Second, always use audited financial statements, if they are available. As we discussed in Chapter 1
,
an audit means that an independent accountant has attested that the financial statements were
correctly prepared and fairly represent the firm's financial condition at a point in time. If the statements
are unaudited, you may need to make an extra effort. For example, if you are a creditor considering
making a loan, you will need to undertake an especially diligent examination of the company's books
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before closing the deal. It would also be a good idea to make sure you know the company's
management team and accountant very well. This will provide additional insight into the credit
worthiness of the firm.
Third, use financial statements that cover three to five years, or more, to conduct your analysis. This
enables you to perform a trend analysis
, which involves looking at historical financial statements to see
how various ratios are increasing, decreasing, or staying constant over time.
Fourth, when possible, it is always best to compare a firm's financial statements with those of
competitors that are roughly the same size and that offer similar products and services. If you compare
firms of disparate size, the results may be meaningless because the two firms may have very different
infrastructures, sources of financing, production capabilities, product mixes, and distribution channels.
For example, comparing The Boeing Company's financial statements with those of Piper Aircraft, a firm
that manufactures small aircraft, makes no sense whatsoever, although both firms manufacture aircraft.
You will have to use your judgment as to whether relevant comparisons can be made between firms
with large size differences.
trend analysis
analysis of trends in financial data
In business it is common to benchmark
a firm's performance, as discussed in the previous paragraph.
The most common type of benchmarking involves comparing a firm's performance with the
performance of similar firms that are relevant competitors. For example, Ford Motor Company may
want to benchmark itself against General Motors and Toyota, its major competitors in the North
American market. Firms can also benchmark against themselves—comparing this year's performance
with last year's, for example—or compare against a goal, such as a 10 percent growth in sales. We
discuss benchmarking in more detail later in the chapter.
benchmark
a standard against which performance is measured
> BEFORE YOU GO ON
1.
Why is it important to look at a firm's historical financial statements?
2.
What is the primary concern of a firm's creditors?
4.2 COMMON-SIZE FINANCIAL STATEMENTS
common-size financial statement
a financial statement in which each number is expressed as a percent of a base number, such as total
assets or total revenues
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A common-size financial statement
is one in which each number is expressed as a percentage of some
base number, such as total assets or total revenues. For example, each number on a balance sheet may
be divided by total assets. Dividing numbers by a common base to form a ratio is called scaling.
It is an
important concept, and you will read more about it later in the chapter, in the discussion of financial
ratios. Financial statements scaled in this manner are also called standardized financial statements.
Common-size financial statements allow you to make meaningful comparisons between the financial
statements of two firms that are different in size. For example, in the oil and gas field equipment
market, Schlumberger Limited is the major competitor of Diaz Manufacturing, the illustrative firm
introduced in Chapter 3
. However, Schlumberger has $19.4 billion in total assets while Diaz
Manufacturing's assets are only $1.9 billion. Without common-size financial statements, comparisons of
these two firms would be difficult to interpret. Commonsize financial statements are also useful for
analyzing trends within a single firm over time, as you will see.
Common-Size Balance Sheets
To create a common-size balance sheet
, we divide each of the asset accounts by total assets. We also
divide each of the liability and equity accounts by total assets since Total assets Total liabilities Total
equity. You can see the common-size balance sheet for Diaz Manufacturing in Exhibit 4.1
. Assets are
shown in the top portion of the exhibit, and liabilities and equity in the lower portion. The calculations
are simple. For example, on the asset side in 2011, cash and marketable securities were 15.3 percent of
total assets ($288.5/$1,889.2 = 0.153), and inventory was 22.4 percent of total assets ($423.8/$1,889.2
= 0.224). Notice that the percentages of total assets add up to 100 percent. On the liability side,
accounts payable are 18.5 percent of total assets ($349.3/$1,889.2 = 0.185), and long-term debt is 30.4
percent ($574.0/$1,889.2 = 0.304). To test yourself, see if you can recreate the percentages in Exhibit
4.1
using your calculator. Make sure the percentages add up to 100, but realize that you may obtain
slight variations from 100 because of rounding.
What kind of information can Exhibit 4.1
tell us about Diaz Manufacturing's operations? Here are
some examples. Notice that in 2011, inventories accounted for 22.4 percent of total assets, down from
24.9 percent in 2010 and 28.6 percent in 2009. In other words, Diaz Manufacturing has been steadily
reducing the proportion of its money tied up in inventory. This is probably good news because it is
usually a sign of more efficient inventory management.
Now look at liabilities and equity, and notice that in 2011 total liabilities represent 50.4 percent of
Diaz Manufacturing's total liabilities and equity. This means that common stockholders have provided
49.6 percent of the firm's total financing and that creditors have provided 50.4 percent of the financing.
In addition, you can see that from 2009 to 2011, Diaz Manufacturing substantially increased the
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proportion of financing from long-term debt holders. Long-term debt provided 21.1 percent
($295.6/$1.398.0 = 0.211) of the financing in 2009 and 30.4 percent ($574.0/$1,889.2 = 0.304) in 2011.
A good source for financial statements is http://finance.yahoo.com
.
Overall, we can identify the following trends in Diaz Manufacturing's common-size balance sheet.
First, Diaz Manufacturing is a growing company. Its assets increased from $1,398.0 million in 2009 to
$1,889.2 million in 2011. Second, the percentage of total assets held in current assets grew from 2009 to
2011, a sign of increasing liquidity. Recall from Chapter 2
that assets are liquid if they can be sold easily
and quickly for cash without a loss of value. Third, the percentage of total assets in plant and equipment
declined from 2009 to 2011, a sign that Diaz Manufacturing is becoming more efficient because it is
using fewer long-term assets in producing sales (below you will see that sales have increased over the
same period). Finally, as mentioned, Diaz Manufacturing has significantly increased the percentage of its
financing from long-term debt. Generally, these are considered signs of a solidly performing company,
but we have a long way to go before we can confidently reach that conclusion. We will now turn to Diaz
Manufacturing's common-size income statement.
EXHIBIT 4.1 Common-Size Balance Sheets for Diaz Manufacturing on December 31 ($ millions)
In common-size balance sheets, such as those in this exhibit, each asset account and each liability and
equity account is expressed as a percentage of total assets. Common-size statements allow financial
analysts to compare firms that are different in size and to identify trends within a single firm over time.
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Common-Size Income Statements
The most useful way to prepare a common-size income statement
is to express each account as a
percentage of net sales, as shown for Diaz Manufacturing in Exhibit 4.2
. Net sales
are defined as total
sales less all sales discounts and sales returns and allowances. You should note that when looking at
accounting information and sales numbers as reported, they almost always mean net sales, unless
otherwise stated. We will follow this convention in the book. Again, the percent calculations are simple.
For example, in 2011 selling and administrative expenses are 14.8 percent of sales ($231.1/$1,563.7 =
0.148), and net income is 7.6 percent of sales ($118.5/$1,563.7 = 0.076). Before proceeding, make sure
that you can verify each percentage in Exhibit 4.2
with your calculator.
Interpreting the common-size income statement is also straightforward. As you move down the
income statement, you will find out exactly what happens to each dollar of sales that the firm generates.
For example, in 2011 it cost Diaz Manufacturing 69.1 cents in cost of goods sold to generate one dollar
of sales. Similarly, it cost 14.8 cents in selling and administrative expenses to generate a dollar of sales.
The government takes 2.8 percent of sales in the form of taxes.
EXHIBIT 4.2 Common-Size Income Statements for Diaz Manufacturing for Fiscal Years Ending
December 31 ($ millions)
Common-size income statements express each account as a percentage of net sales. These statements
allow financial analysts to better compare firms of different sizes and to analyze trends in a single firm's
income statement accounts over time.
This MSN Web site offers lots of financial information, including ratios of firms of your
choice: http://moneycentral.msn.com/investor/research/welcome.asp
.
The common-size income statement can tell us a lot about a firm's efficiency and profit-ability. For
example, in 2009, Diaz Manufacturing's cost of goods sold and selling and administrative expenses
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totaled 86.9 percent of sales (73.0 + 13.9 = 86.9). By 2011, these expenses declined to 83.9 percent of
sales (69.1 + 14.8 = 83.9). This might mean that Diaz Manufacturing is negotiating lower prices from its
suppliers or is more efficient in its use of materials and labor. Or it could mean that the company is
getting higher prices for its products, perhaps by offering fewer discounts or rebates. The important
point, however, is that more of each sales dollar is contributing to net income.
The trends in the income statement and balance sheet suggests that Diaz Manufacturing is improving
along a number of dimensions. The real question, however, is whether Diaz Manufacturing is performing
as well as other firms in the same industry. For example, the fact that 7.6 cents of every sales dollar
reaches the bottom line may not be a good sign if we find out that Diaz Manufacturing's competitors
average 10 cents of net income for every sales dollar.
> BEFORE YOU GO ON
1.
Why does it make sense to standardize financial statements?
2.
What are common-size, or standardized, financial statements, and how are they prepared?
4.3 FINANCIAL RATIOS AND FIRM PERFORMANCE
In addition to the common-size ratios we have just discussed, other specialized financial ratios help
analysts interpret the myriad of numbers in financial statements. In this section we examine financial
ratios that measure a firm's liquidity, efficiency, leverage, profitability, and market value, using Diaz
Manufacturing as an example. Keep in mind that for ratio analysis to be most useful, it should also
include trend and benchmark analysis, which we discuss in more detail later in the chapter.
Why Ratios Are Better Measures
A financial ratio
is simply one number from a financial statement that has been divided by another
financial number. Like the percentages in common-size financial statements, ratios eliminate problems
arising from differences in size because the denominator of the ratio adjusts, or scales, the numerator to
a common base.
financial ratio
A number from a financial statement that has been scaled by dividing by another financial number
Here's an example. Suppose you want to assess the profitability of two firms. Firm A's net income is
$5, and firm B's is $50. Which firm had the best performance? You really cannot tell because you have
no idea what asset base was used to generate the income. In this case, a relevant measure of financial
performance for a stockholder might be net income scaled by the firm's stockholders' equity—that is,
the return on equity (ROE):
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If firm A's total stockholders' equity is $25 and firm B's stockholders' equity is $5,000, the ROE for each
firm is as follows:
As you can see, the ROE for firm A is 20 percent—much larger than the ROE for firm B at 1 percent. Even
though firm B had the higher net income in absolute terms ($50 versus $5), its stockholders had
invested more money in the firm ($5,000 versus $25), and it generated less income per dollar of
invested equity than firm A. Clearly, firm A's performance is better than firm B's, given its smaller equity
investment. The bottom line is that accounting numbers are more easily compared and interpreted
when they are scaled.
Choice of Scale Is Important
An important decision is your choice of the “size factor” for scaling. The size factor you select must be
relevant and make economic sense. For example, suppose you want a measure that will enable you to
compare the productivity of employees at a particular plant with the productivity of employees at other
plants that make similar products. Your assistant makes a suggestion: divide net income by the number
of parking spaces available at the plant. Will this ratio tell you how productive labor is at a plant? Clearly,
the answer is no.
Your assistant comes up with another idea: divide net income by the number of employees. This ratio
makes sense as a measure of employee productivity. A higher ratio indicates that employees are more
productive because, on average, each employee is generating more income. In business, the type of
variable most commonly used for scaling is a measure of size, such as total assets or total net sales.
Other scaling variables are used in specific industries where they are especially informative. For
example, in the airline industry, a key measure of performance is revenue per available seat mile; in the
steel industry, it is sales or cost per ton; and in the automobile industry, it is cost per car.
Other Comments on Ratios
The ratios we present in this chapter are widely accepted and are almost always included in any financial
workup. However, you will find that different analysts will compute many of these standard ratios
slightly differently. Modest variation in how ratios are computed are not a problem as long as the
analyst carefully documents the work done and discloses the ratio formula. These differences are
particularly important when you are comparing data from different sources.
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Short-Term Liquidity Ratios
Liquid assets have active secondary markets and can be sold quickly for cash without a loss of value.
Some assets are more liquid than others. For example, short-term marketable securities are very liquid
because they can be easily sold in the secondary market at or near the original purchase price. In
contrast, plant and equipment can take months or years to sell and often must be sold substantially
below the cost of building or acquiring them.
When we examine a company's liquidity position
, we want to know whether the firm can pay its bills
when cash from operations is insufficient to pay short-term obligations, such as payroll, invoices from
vendors, and maturing bank loans. As the name implies, short-term liquidity ratios
focus on whether the
firm has the ability to convert current assets into cash quickly without loss of value. As we have noted
before, even a profitable business can fail if it cannot pay its current bills on time. The inability to pay
debts when they are due is known as insolvency
. Thus, liquidity ratios are also known as short-term
solvency ratios.
The two most important liquidity ratios are the current ratio and the quick ratio.
insolvency
the inability to pay debts when they are due
The Current Ratio
To calculate the current ratio, we divide current assets by current liabilities.
1
The formula is presented
below, along with a calculation of the current ratio for Diaz Manufacturing for 2011 based on balance
sheet account data from Exhibit 4.1
:
Diaz Manufacturing's current ratio is 2.75, which should be read as “2.75 times.” What does this number
mean? If Diaz Manufacturing were to take its current supply of cash and add to it the proceeds of
liquidating its other current assets—such as marketable securities, accounts receivable, and inventory—
it would have $1,039.8 million. This $1,039.8 million would cover the firm's short-term obligations of
$377.8 million approximately 2.75 times, leaving a “cushion” of $662.0 million ($1,039.8 − $377.8 =
$662.0).
Now turn to Exhibit 4.3
, which shows the ratios discussed in this chapter for Diaz Manufacturing for
the three-year period 2009–2011. The exhibit will allow us to identify important trends in the company's
financial statements. Note that Diaz Manufacturing's current ratio has been steadily increasing over
time. What does this trend mean? From the perspective of a potential creditor, it is a positive sign. To a
potential creditor, more liquidity is better because it means that the firm has a greater ability, at least in
the short term, to make payments. From a stockholder's perspective, however, too much liquidity is not
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necessarily a good thing. If we were to discover that Diaz Manufacturing has a much higher current ratio
than its competitors, it could mean that management is being too conservative by keeping too much
money tied up in current assets, leaving less cash flow for investors. Generally, more liquidity is better
and is a sign of a healthy firm. Only a benchmark analysis can tell us the complete story, however.
The Quick Ratio
The quick ratio is similar to the current ratio except that inventory is subtracted from current assets in
the numerator. This change reflects the fact that inventory is often much less liquid than other current
assets. Inventory is the most difficult current asset to convert to cash without loss of value. Of course,
the liquidity of inventory varies with the industry. For example, inventory of a raw material commodity,
such as gold or crude oil, is more likely to be sold with little loss in value than inventory consisting of
perishables, such as fruit, or fashion items, such as basketball shoes. Another reason for excluding
inventory in the quick ratio calculation is that the book value of inventory may be significantly more than
its market value because it may be obsolete, partially completed, spoiled, out of fashion, or out of
season.
To calculate the quick ratio—or acid-test ratio
, as it is sometimes called—we divide current assets,
less inventory, by current liabilities. The calculation for Diaz Manufacturing for 2011 is as follows, based
on balance sheet data from Exhibit 4.1
:
EXHIBIT 4.3 Ratios for Time-Trend Analysis for Diaz Manufacturing for Fiscal Years Ending December
31
Comparing how financial ratios, such as these ratios for Diaz Manufacturing, change over time enables
financial analysts to identify trends in company performance.
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Note:
Numbers may not add up because of rounding.
The quick ratio of 1.63 times means that if we exclude inventory, Diaz Manufacturing had $1.63 of
current assets for each dollar of current liabilities. You can see from Exhibit 4.3
that Diaz
Manufacturing's liquidity position, as measured by its quick ratio, has been increasing over time.
Note that the quick ratio is usually less than the current ratio, as it was for Diaz Manufacturing in
2011.
2
The quick ratio is a very conservative measure of liquidity because the calculation assumes that
the inventory is valued at zero, which in most cases is not a realistic assumption. Even in a bankruptcy
“fire sale,” the inventory can be sold for some small percentage of its book value, generating at least
some cash.
Efficiency Ratios
We now turn to a group of ratios called efficiency ratios
or asset turnover ratios
, which measure how
efficiently a firm uses it assets. These ratios are quite useful for managers and financial analysts in
identifying the inefficient use of current and long-term assets. They are also valuable for a firm's
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investors who use the ratios to find out how quickly a firm is selling its inventory and converting
receivables into cash flow for investors.
Inventory Turnover and Days' Sales in Inventory
We measure inventory turnover by dividing the cost of goods sold from the income statement by
inventory from the balance sheet (see Exhibits 4.1
and 4.2
). The cost of goods sold is used because it
reflects the book value of the inventory that is sold by a firm. The formula for inventory turnover and its
value for Diaz Manufacturing in 2011 are:
EXAMPLE 4.1 DECISION MAKING
The Liquidity Paradox
SITUATION:
You are asked by your boss whether Wal-Mart or H&R Block is more liquid. You have the
following information:
You also know that Wal-Mart carries a large inventory and that H&R Block is a service firm that
specializes in income-tax preparation. Which firm is the most liquid? Your boss asks you to explain the
reasons for your answers, and also to explain why H&R Block's current and quick ratios are virtually the
same.
DECISION:
H&R Block is much more liquid than Wal-Mart. The difference between the quick ratios—
0.26 versus 1.05—pretty much tells the story. Inventory is the least liquid of all the current assets.
Because H&R Block does not manufacture or sell goods, it has no product inventory; hence, the current
and quick ratios are virtually equal. Wal-Mart has a lot of inventory relative to the rest of its current
assets, and that explains the large numerical drop between the current and quick ratios.
The firm “turned over” its inventory 2.55 times during the year. Looking back at Exhibit 4.3
, you can see
that this ratio remained about the same over the period covered.
What exactly does “turning over” inventory mean? Consider a simple example. Assume that a firm
starts the year with inventory worth $100 and replaces the inventory when it is all sold; that is, the
inventory goes to zero. Over the course of the year, the firm sells the inventory and replaces it three
times. For the year, the firm has an inventory turnover of three times.
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As a general rule, turning over inventory faster is a good thing because it means that the firm is doing
a good job of minimizing its investment in inventory. Nevertheless, like all ratios, inventory turnover can
be either too high or too low. Too high of an inventory turnover ratio may signal that the firm has too
little inventory for its customers and could be losing sales as a result. If the firm's inventory turnover
level is too low, it could mean that management is not managing the firm's inventory efficiently or that
an unusually large portion of the inventory is obsolete or out of date. In sum, inventory turnover that is
significantly lower or significantly higher than that of competitors calls for further investigation.
Based on the inventory turnover figure, and using a 365-day year, we can also calculate the days'
sales in inventory
, which tells us how long it takes a firm to turn over its inventory on average. The
formula for days' sales in inventory, along with the 2011 calculation for Diaz Manufacturing, is as
follows:
Note that inventory turnover in the formula is computed from Equation 4.3. On average, Diaz
Manufacturing takes about 140 days to turn over its inventory. Generally speaking, the smaller the
number, the more efficient the firm is at moving its inventory.
Alternative Calculation for Inventory Turnover
Normally, we determine inventory turnover by dividing cost of goods sold by the inventory level at the
end of the period. However, if a firm's inventory fluctuates widely or is growing (or decreasing) over
time, some analysts prefer to compute inventory turnover using the average inventory value for the
time period. In this case, the inventory turnover is calculated in two steps:
1.
We first calculate average inventory by adding beginning and ending inventory and dividing by 2:
2.
We then divide the cost of goods sold by average inventory to find inventory turnover:
Note that all six efficiency ratios presented in the chapter (Equations 4.3 through 4.8) can be computed
using an average asset value. For simplicity, we will generally use the end of the period asset value in
our calculations.
APPLICATION 4.1 LEARNING BY DOING
Alternative Calculations for Efficiency Ratios
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PROBLEM:
For Diaz Manufacturing, compute the inventory turnover based on the average inventory.
Then compare that value with 2.55, the turnover ratio based on Equation 4.3. Why do you think the two
values differ?
APPROACH:
Use the alternative calculation described above. In comparing the two values, you want to
consider fluctuations in inventory over time.
SOLUTION:
The inventory turnover computed with average inventory, 2.71 times, is slightly higher than 2.55
because the inventory increased during the year.
Accounts Receivable Turnover and Days' Sales Outstanding
Many firms make sales to their customers on credit, which creates an account receivable on the balance
sheet. It does not do the firm much good to ship products or provide the services on credit if it cannot
ultimately collect the cash from its customers. A firm that collects its receivables faster is generating
cash faster. We can measure the speed at which a firm converts its receivables into cash with a ratio
called accounts receivable turnover; the formula and calculated values for Diaz Manufacturing in 2011
are as follows:
The data to compute this ratio is from Diaz's balance sheet and income statement (
Exhibits 4.1
and 4.2
).
Roughly, this ratio means that Diaz Manufacturing loans out and collects an amount equal to its
outstanding accounts receivable 5.11 times over the course of a year.
In most circumstances
, higher accounts receivable turnover is a good thing—it means that the firm is
making fewer sales on credit and collecting cash payments from its credit customers faster. Such credit
is a customer incentive that is used to promote sales, but it can be expensive. As shown in Exhibit 4.3
,
Diaz's collection speed slowed down slightly from 2009 to 2011. This may be a cause for management
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concern for at least three reasons. First, Diaz's system for collecting accounts receivable may be
inefficient. Second, the firm's customers may not be paying on time because their businesses are
slowing down due to industry or general economic conditions. Finally, Diaz may be extending credit to
customers that are poor credit risks. Making a determination of the cause would require us to compare
Diaz's accounts receivable turnover with corresponding figures from its competitors.
You may find it easier to evaluate a firm's credit and collection policies by using days' sales
outstanding, often referred to as DSO, which is calculated as follows:
Note that accounts receivable turnover is computed from Equation 4.5. The DSO for Diaz Manufacturing
means that, on average, the company converts its credit sales into cash in 71.43 days. DSO is commonly
called the average collection period.
Generally, faster collection is better. Whether 71.43 days is fast enough really depends on industry
norms and on the credit terms Diaz Manufacturing extends to its customers. For example, if the industry
average DSO is 77 days and Diaz Manufacturing gives customers 90 days to pay, then a DSO of 71.43
days is an indication of good management. If, in contrast, Diaz gives customers 60 days to pay, the
company has a problem, and management needs to determine why customers are not paying on time.
Asset Turnover Ratios
We turn next to a discussion of some broader efficiency ratios. In this section we discuss two ratios that
measure how efficiently management is using the firm's assets to generate sales.
Total asset turnover measures the dollar amount of sales generated with each dollar of total assets.
Generally, the higher the total asset turnover, the more efficiently management is using total assets.
Thus, if a firm increases its asset turnover, management is squeezing more sales out of a constant asset
base. When a firm's asset turnover ratio is high for its industry, the firm may be approaching full
capacity. In such a situation, if management wants to increase sales, it will need to make an investment
in additional fixed assets. Total asset turnover should be interpreted with care when examining trends
for a given firm or when benchmarking against competitors. Younger firms and firms with more recent
purchases of fixed assets will have a higher book value of assets and therefore lower total asset turnover
for a given level of net sales.
The formula for total asset turnover and the calculation for Diaz Manufacturing's turnover value in
2011 (based on data from Exhibits 4.1
and 4.2
) are as follows:
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Total asset turnover for Diaz Manufacturing is 0.83 times. In other words, in 2011, Diaz Manufacturing
generated $0.83 in sales for every dollar in assets. In Exhibit 4.3
you can see that Diaz Manufacturing's
total asset turnover has declined slightly since 2009. This does not necessarily mean that the company's
management team is performing poorly. The decline could be part of a typical industry sales cycle, or it
could be due to a slowdown in the business of Diaz Manufacturing's customers. As always, getting a
better fix on potential problems requires comparing Diaz Manufacturing's total asset turnover with
comparable figures for its close competitors.
The turnover of total assets is a “big picture” measure. In addition, management may want to see
how particular types of assets are being put to use. A common asset turnover ratio measures sales per
dollar invested in fixed assets (plant and equipment). The fixed asset turnover formula and the 2011
calculation for Diaz are:
Diaz Manufacturing generated $3.92 of sales for each dollar of net fixed assets in 2011, which is an
increase over the 2010 value of $3.52. This means that the firm is generating more sales for every dollar
in fixed assets. In a manufacturing firm that relies heavily on plant and equipment to generate output,
the fixed asset turnover number is an important ratio. In contrast, in a service-industry firm with little
plant and equipment, total
asset turnover is more relevant.
EXAMPLE 4.2 DECISION MAKING
Ranking Firms by Fixed Asset Turnover
SITUATION:
Different industries use different amounts of fixed assets to generate their revenues. For
example, the airline industry is capital intensive, with large investments in airplanes, whereas firms in
service industries use more human capital (people) and have very little invested in fixed assets. As a
financial analyst, you are given the following fixed asset turnover ratios: 1.56, 3.91, and 11.23. You must
decide which ratios match up with three firms: Delta Air Lines, H&R Block, and Wal-Mart. Make this
decision, and explain your reasoning.
DECISION:
At the extremes, Delta is a capital-intensive firm, and H&R Block is a service firm. We would
expect firms with large investments in fixed assets (Delta) to have lower asset turnover than service-
industry firms, which have few fixed assets. Wal-Mart is the middle-ground firm, with fixed asset
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holdings primarily in stores and land. Thus, the firms and their respective fixed asset turnovers are: Delta
= 1.56, Wal-Mart = 3.91, and H&R Block = 11.23.
Leverage Ratios
Leverage ratios
measure the extent to which a firm uses debt rather than equity financing and indicate
the firm's ability to meet its long-term financial obligations, such as interest payments on debt and lease
payments. The ratios are also called long-term solvency ratios.
They are of interest to the firm's
creditors, stockholders, and managers. Many different leverage ratios are used in industry; in this
chapter we present some of the most widely used.
Financial Leverage
financial leverage
the use of debt in a firm's capital structure; the more debt, the higher the financial leverage
The term financial leverage
refers to the use of debt in a firm's capital structure. When a firm uses debt
financing, rather than only equity financing, the returns to stockholders may be magnified. This so-called
leveraging effect occurs because the interest payments associated with debt are fixed, regardless of the
level of the firm's operating profits. On the one hand, if the firm's operating profits increase from one
year to the next, debt holders continue to receive only their fixed-interest payments, and all of the
increase goes to the stockholders. On the other hand, if the firm falls on hard times and suffers an
operating loss, debt holders receive the same fixed-interest payment (assuming that the firm does not
go bankrupt), and the loss is charged against the stockholders' equity. Thus, debt increases the returns
to stockholders during good times and reduces the returns during bad times. In Chapter 16
we discuss
financial leverage in greater depth and present a detailed example of how debt financing creates the
leveraging effect.
default risk
the risk that a firm will not be able to pay its debt obligations as they come due
The use of debt in a company's capital structure increases the firm's default risk
—the risk that it will
not be able to pay its debt as it comes due. The explanation is, of course, that debt payments are a fixed
obligation and debt holders must be paid the interest and principal payments they are owed, regardless
of whether the company earns a profit or suffers a loss. If a company fails to make an interest payment
on the prescribed date, the company defaults on its debt and could be forced into bankruptcy by
creditors.
Debt Ratios
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We next look at three leverage ratios that focus on how much debt, rather than equity, the firm employs
in its capital structure. The more debt a firm uses, the higher its financial leverage, the more volatile its
earnings, and the greater its risk of default.
Total Debt Ratio.
The total debt ratio measures the extent to which the firm finances its assets from
sources other than the stockholders. The higher the total debt ratio, the more debt the firm has in its
capital structure. The total debt ratio and a calculation for Diaz Manufacturing for 2011 based on data
from Exhibit 4.1
appear as follows:
How do we determine the figure to use for total debt? Many variations are used, but perhaps the
easiest is to subtract total equity from total assets. In other words, total debt is equal to total liabilities.
A common alternative measure of debt is the sum of all the firm's interest bearing liabilities, such as
notes payable and long-term debt. Using data from Exhibit 4.1
, we can calculate total debt for Diaz
Manufacturing in 2011 as follows:
As you can see from Equation 4.9, the total debt ratio for Diaz Manufacturing is 0.50, which means
that 50 percent of the company's assets are financed with debt. Looking back at Exhibit 4.3
, we find that
Diaz Manufacturing increased its use of debt from 2010 to 2011. The current total debt ratio of 50
percent appears high, raising questions about the company's financing strategy. Whether a high or low
value for the total debt ratio is good or bad, however, depends on how the firm's capital structure
affects the value of the firm. We explore this topic in greater detail in Chapter 16
.
We turn next to two common variations of the total debt ratio: the debt-to-equity ratio and the
equity multiplier.
Debt-to-Equity Ratio.
The
total debt ratio
tells us the amount of debt for each dollar of total assets.
The
debt-to-equity ratio
tells us the amount of debt for each dollar of equity. Based on data from Exhibit
4.1
, Diaz Manufacturing's debt-to-equity ratio for 2011 is 1.02:
The total debt ratio and the debt-to-equity ratio are directly related by the following formula, shown
with a calculation for Diaz Manufacturing:
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As you can see, once you know one of these ratios, you can compute the other. Which of the two ratios
you use is really a matter of personal preference.
APPLICATION 4.2 LEARNING BY DOING
Finding a Total Debt Ratio
PROBLEM:
A firm's debt-to-equity ratio is 0.5. What is the firm's total debt ratio?
APPROACH:
Use the equation that relates the total debt ratio to the debt-to-equity ratio.
SOLUTION:
APPLICATION 4.3 LEARNING BY DOING
Solving for an Unknown Using the Debt-to-Equity Ratio
PROBLEM:
You are given the follow information about H&R Block's year-end balance sheet for 2010.
The firm's debt-to-equity ratio is 2.63, and its total equity is $1.44 billion. Determine the book
(accounting) values for H&R Block's total debt and total assets.
APPROACH:
We know that the debt-to-equity ratio is 2.63 and that total equity is $1.44 billion. We also
know that the debt-to-equity ratio (Equation 4.10) is equal to total debt divided by total equity, and we
can use this information to solve for total debt. Once we have a figure for total debt, we can use the
basic accounting identity to solve for total assets.
SOLUTION:
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Equity Multiplier.
The equity multiplier tells us the amount of assets that the firm has for every dollar of
equity. Diaz Manufacturing's equity multiplier ratio is 2.02, as shown here:
Notice that the equity multiplier is directly related to the debt-to-equity ratio:
This is no accident. Recall the balance sheet identity: Total assets Total liabilities (debt) Total
stockholders' equity. This identity can be substituted into the numerator of the equity multiplier formula
(Equation 4.11):
Therefore, all three of these leverage ratios (Equations 4.9–4.11) are related by the balance sheet
identity, and once you know one of the three ratios, you can compute the other two ratios.
Coverage Ratios
A second type of leverage ratio measures the firm's ability to service its debt, or how easily the firm can
“cover” debt payments out of earnings or cash flow. What does “coverage” mean? If your monthly take-
home pay from your part-time job is $400 and the rent on your apartment is $450, you are going to be
in some financial distress because your income does not “cover” your $450 fixed obligation to pay the
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rent. If, on the other hand, your take-home pay is $900, your monthly coverage ratio with respect to
rent is $900/$450 2 times. This means that for every dollar of rent you must pay, you earn two dollars of
revenue. The higher your coverage ratio, the less likely you will default on your rent payments.
Times Interest Earned.
Our first coverage ratio is times interest earned, which measures the extent to
which operating profits (earnings before interest and taxes, or EBIT) cover the firm's interest expenses.
Creditors prefer to lend to firms whose EBIT is far in excess of their interest payments. The equation for
the times-interest-earned ratio and a calculation for Diaz Manufacturing from its income statement
(
Exhibit 4.2
) for 2011 are:
Diaz Manufacturing can cover its interest charges about 30 times with its operating income. This figure
appears to point to a good margin of safety for creditors. In general, the larger the times interest earned
the more likely the firm is to meet its interest payments.
Cash Coverage.
As we have discussed before, depreciation is a noncash expense, and as a result, no cash
goes out the door when depreciation is deducted on the income statement. Thus, rather than asking
whether operating profits (EBIT) are sufficient to cover interest payments, we might ask how much cash
is available to cover interest payments. The cash a firm has available from operations to meet interest
payments are better measured by EBIT plus depreciation and amortization (EBITDA).
3
Thus, the cash
coverage ratio for Diaz Manufacturing in 2011 is:
For a firm with depreciation or amortization expenses, which includes virtually all firms, EBITDA
coverage will be larger than times interest earned coverage.
Profitability Ratios
Profitability ratios
measure management's ability to efficiently use the firm's assets to generate sales
and manage the firm's operations. These measurements are of interest to stockholders, creditors, and
managers because they focus on the firm's earnings. The profitability ratios presented in this chapter are
among a handful of such ratios commonly used by stockholders, managers, and creditors when
analyzing a firm's performance. In general, the higher the profit-ability ratios, the better the firm is
performing.
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Gross Profit Margin
The gross profit margin measures the percentage of net sales remaining after the cost of goods sold is
paid. It captures the firm's ability to manage the expenses directly associated with producing the firm's
products or services. Next we show the gross profit margin formula, along with a calculation for Diaz
Manufacturing in 2011, using data from
Exhibit 4.2
:
Thus, after paying the cost of goods sold, Diaz Manufacturing has 30.86 percent of the sales amount
remaining to pay other expenses. From Exhibit 4.3
, you can see that Diaz Manufacturing's gross profit
margin has been increasing over the past several years, which is good news.
Operating Profit Margin and EBITDA Margin
Moving farther down the income statement, you can measure the percentage of sales that remains after
payment of cost of goods sold and all other expenses, except for interest and taxes. Operating profit is
typically measured as EBIT. The operating profit margin, therefore, gives an indication of the profitability
of the firm's operations, independent of its financing policies or tax management strategies. The
operating profit margin formula, along with Diaz Manufacturing's 2011 operating profit margin
calculated using data from Exhibit 4.2
, is as follows:
Many analysts and investors are concerned with cash flows generated by operations rather than
operating earnings and will use EBITDA in the numerator instead of EBIT. Calculated in this way, the
operating profit margin is known as the EBITDA margin.
Net Profit Margin
The net profit margin is the percentage of sales remaining after all of the firm's expenses, including
interest and taxes, have been paid. The net profit margin formula is shown here, along with the
calculated value for Diaz Manufacturing in 2011, using data from the firm's income statement (
Exhibit
4.2
):
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As you can see from Exhibit 4.3
, Diaz Manufacturing's net profit margin improved dramatically from
2009 to 2011. This is good news. The question remains, however, whether 7.58 percent is a good profit
margin in an absolute sense. Answering this question requires that we compare Diaz Manufacturing's
performance to the performance of its competitors, which we will do later in this chapter. What
qualifies as a good profit margin varies significantly across industries. Generally speaking, the higher a
company's profit margin, the better the company's performance.
Return on Assets
So far, we have examined profitability as a percentage of sales. It is also important that we analyze
profitability as a percentage of investment, either in assets or in equity. First, let's look at return on
assets. In practice, return on assets is calculated in two different ways.
One approach provides a measure of operating profit (EBIT) per dollar of assets. This is a powerful
measure of return because it tells us how efficiently management utilized the assets under their
command, independent of financing decisions and taxes. It can be thought of as a measure of the pre-
tax return on the total net investment in the firm from operations. The formula for this version of return
on assets, which we call EBIT return on assets (EROA), is shown next, together with the calculated value
for Diaz Manufacturing in 2011, using data from Exhibits 4.1
and 4.2
:
Exhibit 4.3
shows us that, unlike the other profitability ratios, Diaz Manufacturing's EROA did not really
improve from 2009 to 2011. The very similar EROA values for 2009 and 2011 indicate that assets
increased at approximately the same rate as operating profits.
Some analysts calculate return on assets (ROA) as:
Although it is a common calculation, we advise against using the calculation in Equation 4.18 unless you
are using the DuPont system, which we discuss shortly. The ROA calculation divides a measure of
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earnings available to stockholders (net income) by total assets (debt plus equity), which is a measure of
the investment in the firm by both stockholders and creditors. Constructing a ratio of those two
numbers is like mixing apples and oranges. The information that this ratio provides about the efficiency
of asset utilization is obscured by the financing decisions the firm has made and the taxes it pays. You
can see this in Exhibit 4.3
, which shows that, in contrast to the very small change in EROA, ROA increases
substantially from 2009 to 2011. This increase in ROA is not due to improved efficiency but rather to a
large decrease in interest expense (see Exhibit 4.2
).
The key point is that EROA surpasses ROA as a measure of how efficiently assets are utilized in
operations. Dividing a measure of earnings to both debt holders and stockholders by a measure of how
much both debt holders and stockholders have invested gives us a clearer view of what we are trying to
measure.
In general, when you calculate a financial ratio, if you have a measure of income to stockholders in
the numerator, you want to make sure that you have only investments by stockholders in the
denominator. Similarly, if you have a measure of total profits from operations in the numerator, you
want to divide it by a measure of total investments by both debt holders and stockholders.
Return on Equity
Return on equity (ROE) measures net income as a percentage of the stockholders' investment in the
firm. The return on equity formula and the calculation for Diaz Manufacturing in 2011 based on data
from Exhibits 4.1
and 4.2
are as follows:
Alternative Calculation of ROA and ROE
As with efficiency ratios, the calculation of ROA and ROE involves dividing an income statement value,
which relates to a period of time, by a balance sheet value from the end of the time period. Some
analysts prefer to calculate ROA and ROE using the average asset value or equity value, where the
average value is determined as follows:
Using the average asset or equity value makes sense because the earnings over a period are generated
with the average value of assets or equity.
APPLICATION 4.4 LEARNING BY DOING
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Alternative Calculations for EROA and ROE Ratios
PROBLEM:
Calculate the EROA and ROE for Diaz Manufacturing using average balance sheet values and
compare the results with the calculations based on Equations 4.17 and 4.19.
APPROACH:
First find average values for the asset and equity accounts using data from Exhibit 4.1
. Then
use these values to calculate the EROA and ROE. In explaining why some analysts might prefer the
alternative calculation, consider possible fluctuations of assets or equity over time.
SOLUTION:
Both EROA (9.96 percent versus 8.91 percent) and ROE (13.32 percent versus 12.64 percent) are higher
when the average values are used. The reason is that Diaz's total assets grew from $1,493.8 million in
2010 to $1,889.2 million in 2011 and its equity grew from $842.2 million to $937.4 million during the
same period.
Market-Value Indicators
The ratios we have discussed so far rely solely on the firm's financial statements, and we know that
much of the data in those statements are historical and do not represent current market value. Also, as
we discussed in Chapter 1
, the appropriate objective for the firm's management is to maximize
stockholder value, and the market value of the stockholders' claims is the value of the cash flows
that
they are entitled to receive, which is not necessarily the same as accounting income. To find out how the
stock market evaluates a firm's liquidity, efficiency, leverage, and profitability, we need ratios based on
market values.
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Over the years, financial analysts have developed a number of ratios, called
market-value ratios
,
which combine market-value data with data from a firm's financial statements. Here we examine the
most commonly used market-value ratios: earnings per share, the price-earnings ratio, and the market-
to-book ratio.
Earnings per Share
Dividing a firm's net income by the number of shares outstanding yields earnings per share (EPS). At the
end of 2011, Diaz Manufacturing had 54,566,054 shares outstanding (see Exhibit 3.1
in Chapter 3
) and
net income of $118.5 million (
Exhibit 4.2
). Its EPS at that point is thus calculated as follows:
Price-Earnings Ratio
The price-earnings (P/E) ratio relates earnings per share to price per share. The formula, with a
calculation for Diaz Manufacturing for the end of 2011, is as follows:
Price per share on a given date can be obtained from listings in the Wall Street Journal
or from an online
source, such as Yahoo! Finance.
What does it mean for a firm to have a price-earnings ratio of 22.4? It means that the stock market
places a value of $22.40 on every $1 of net income. Why are investors willing to pay $22.40 for a claim
on $1 of earnings? The answer is that the stock price does not only reflect the earnings this year. It
reflects all future cash flows from earnings, and the especially high P/E ratio can indicate that investors
expect the firm's earnings to grow in the future. Alternatively, a high P/E ratio might be due to unusually
low earnings in a particular year and investors might expect earnings to recover to a normal level soon.
We will discuss how expected growth affects P/E ratios in detail in later chapters. As with other
measures, to understand whether the P/E ratio is too high or too low, we must compare the firm's P/E
ratio with those of competitors and also look at movements in the firm's P/E ratio relative to market
trends.
Market-to-Book Ratio
The Market-to-Book ratio compares the market value of the firm's investments to their book value. The
formula, with a calculation for Diaz at the end of 2011, is:
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Book value per share is an accounting number that reflects the cumulative historical investment into the
firm's equity account on a per share basis. Market value of equity per share is simply the price per share.
A higher market-to-book ratio suggests that the firm has been more effective at investing in projects
that add value for its stockholders. A value of less than one could mean that the firm has not created
any value for its stockholders.
Concluding Comments on Ratios
We could have covered many more ratios. However, the group of ratios presented in this chapter is a
fair representation of the ratios needed to analyze the performance of a business. When using ratios, it
is important that you ask yourself, “What does this ratio mean, and what is it measuring?” rather than
trying to memorize a definition. Good ratios should make good economic sense when you look at them.
> BEFORE YOU GO ON
1.
What are the efficiency ratios, and what do they measure? Why, for some firms, is the total asset turnover more important than the fixed asset turnover?
2.
List the leverage ratios discussed in this section, and explain how they are related.
3.
List the profitability ratios discussed in this section, and explain how they differ from each other.
4.4 THE DUPONT SYSTEM: A DIAGNOSTIC TOOL
By now, your mind may be swimming with ratios. Fortunately, some enterprising financial managers at
the DuPont Company developed a system in the 1960s that ties together some of the most important
financial ratios and provides a systematic approach to financial ratio analysis.
An Overview of the DuPont System
The DuPont system of analysis is a diagnostic tool that uses financial ratios to evaluate a company's
financial health. The process has three steps. First, management assesses the company's financial health
using the DuPont ratios. Second, if any problems are identified, management corrects them. Finally,
management monitors the firm's financial performance over time, looking for differences from ratios
established as benchmarks by management.
Under the DuPont system, management is charged with making decisions that maximize the firm's
return on equity (ROE) as opposed to maximizing the value of the stockholders' shares. The system is
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primarily designed to be used by management as a diagnostic and corrective tool, though investors and
other stakeholders have found its diagnostic powers of interest.
The DuPont system is derived from two equations that link the firm's return on assets (ROA) and
return on equity (ROE). The system identifies three areas where management should focus its efforts in
order to maximize the firm's ROE: (1) how much profit management can earn on sales, (2) how efficient
management is in using the firm's assets, and (3) how much financial leverage management is using.
Each of these areas is monitored by a single ratio, and together the ratios comprise the
DuPont
equation
.
The ROA Equation
The ROA equation links the firm's return on assets with its total asset turnover and net profit margin.
We derive this relation from the ROA equation as follows:
As you can see, we start with the ROA formula presented earlier as Equation 4.18. Then we multiply ROA
by net sales divided by net sales. In the third line, we rearrange the terms, coming up with the
expression ROA (Net income/Net sales) × (Net sales/Total assets). You may recognize the first ratio in
the third line as the firm's net profit margin (Equation 4.16) and the second ratio as the firm's total asset
turnover (Equation 4.7). Thus, we end up with the final equation for ROA, which is restated as Equation
4.23:
Equation 4.23 says that a firm's ROA is determined by two factors: (1) the firm's net profit margin and (2)
the firm's total asset turnover. Let's look at the managerial implications of each of these terms.
Net Profit Margin.
The net profit margin ratio can be written as follows:
As you can see, the net profit margin can be viewed as the product of three ratios: (1) the operating
profit margin (EBIT/Net sales), which is Equation 4.15, (2) a ratio that measures the impact of interest
expenses on profits (EBT/EBIT), and (3) a ratio that measures the impact of taxes on profits (Net
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income/EBT). Thus, the net profit margin focuses on management's ability to generate profits from sales
by efficiently managing the firm's (1) operating expenses, (2) interest expenses, and (3) tax expenses.
Total Asset Turnover.
Total asset turnover, which is defined as Net sales/Total assets, measures how
efficiently management uses the assets under its command—that is, how much output management can
generate with a given asset base.
Net Profit Margin versus Total Asset Turnover
The ROA equation provides some very interesting managerial insights. It says that if management wants
to increase the firm's ROA, it can increase the net profit margin, total asset turnover, or both. Of course,
every firm would like to make both terms as large as possible so as to earn the highest possible ROA.
Though every industry is different, competition, marketing considerations, technology, and
manufacturing capabilities, to name a few, place upper limits on asset turnover and net profit margins
and, thus, ROA. Equation 4.23 suggests that management can follow two distinct strategies to maximize
ROA. Deciding between the strategies involves a trade-off between total asset turnover and net profit
margin.
The first management strategy emphasizes high profit margin and low asset turnover. Examples of
companies that use this strategy are luxury stores, such as jewelry stores, high-end department stores,
and upscale specialty boutiques. Such stores carry expensive merchandise that has a high profit margin
but tends to sell slowly. The second management strategy depends on low profit margins and high
turnover. Typical examples of firms that use this strategy are discount stores and grocery stores, which
have very low profit margins but make up for it by turning over their inventory very quickly. A typical
chain grocery store, for example, turns over its inventory more than 12 times per year.
Exhibit 4.4
illustrates both strategies. The exhibit shows asset turnover, profit margin, and ROA for
four retailing firms in 2009. Tiff any & Co. is a nationwide retailer of high-end jewelry, and Polo Ralph
Lauren stores are upscale boutiques that carry expensive casual wear for men and women. At the other
end of the spectrum are Wal-Mart, which is famous for its low-price, high-volume strategy, and Whole
Foods Markets, a grocery chain based in Austin, Texas.
Notice that the two luxury-item stores (Tiff any & Co. and Polo Ralph Lauren) have lower asset
turnover and higher profit margins, while the discount and grocery stores have lower profit margins and
much higher asset turnover. Whole Foods and Wal-Mart are strong financial performers in their industry
sectors. Whole Foods' ROA of 3.88 percent reflects tight competition in the grocery business. Both Polo
Ralph Lauren and Tiff any & Co. are top performers in their industries, and their high ROAs (9.13 and
7.10, respectively) corroborate that fact.
EXHIBIT 4.4 Two Basic Strategies to Earn a Higher ROA
a
To maximize a firm's ROA, management can focus more on achieving high profit margins or on achieving
high asset turnover. High-end retailers like Polo Ralph Lauren and Tiffany & Co. focus more on achieving
high profit margins. In contrast, grocery and discount stores like Whole Foods Market and Wal-Mart
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tend to focus more on achieving high asset turnover because competition limits their ability to achieve
very high profit margins.
a
Ratios are calculated using financial results for 2009.
The ROE Equation
To derive the ROE equation, we start with the formula from Equation 4.19:
Next, we multiply by total assets divided by total assets, and then we rearrange the terms so that ROE
(Net income/Total assets) × (Total assets/Total equity), as shown in the third line. By this definition, ROE
is the product of two ratios already familiar to us: ROA (Equation 4.18) and the equity multiplier
(Equation 4.11). The equation for ROE is shown as Equation 4.24:
Interesting here is the fact that ROE is determined by the firm's ROA and its use of leverage. The greater
the use of debt in the firm's capital structure, the greater the ROE. Thus, increasing the use of leverage is
one way management can increase the firm's ROE—but at a price. That is, the greater the use of
financial leverage, the more risky the firm. How aggressively a company uses this strategy depends on
management's preferences for risk and the willingness of creditors to lend money and bear the risk.
The DuPont Equation
Now we can combine our two equations into a single equation. From Equation 4.24, we know that ROE =
ROA
× Equity multiplier; and from Equation 4.23, we know that ROA = Net profit margin × Total asset
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turnover. Substituting Equation 4.23 into Equation 4.24 yields an expression formally called the DuPont
equation, as follows:
We can also express the DuPont equation in ratio form:
To check the DuPont relation, we will use some values from Exhibit 4.3
, which lists financial ratios for
Diaz Manufacturing. For 2011, Diaz's net profit margin is 7.58 percent, total asset turnover is 0.83, and
the equity multiplier is 2.02. Substituting these values into Equation 4.25 yields:
With rounding error, this agrees with the value computed for ROE using Equation 4.19.
Applying the DuPont System
In summary, the DuPont equation tells us that a firm's ROE is determined by three factors: (1) net profit
margin, which measures the firm's operating efficiency and how it manages its interest expense and
taxes; (2) total asset turnover, which measures the efficiency with which the firm's assets are utilized;
and (3) the equity multiplier, which measures the firm's use of financial leverage. The schematic diagram
in Exhibit 4.5
shows how the three key DuPont ratios are linked together and how they relate to the
balance sheet and income statement for Diaz Manufacturing.
The DuPont system of analysis is a useful tool to help identify problem areas within a firm. For
example, suppose that North Sails Group, a sailboat manufacturer located in San Diego, California, is
having financial difficulty. The firm hires you to find out why the ship is financially sinking. The firm's CFO
has you calculate the DuPont ratio values for the firm and obtain some industry averages to use as
benchmarks, as shown.
Clearly, the firm's ROE is quite low compared to its industry (8 percent versus 16 percent), so without
question the firm has problems. Next, you examine the values for the firm's ROA and equity multiplier.
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The firm's use of financial leverage is equal to the industry standard of 2 times, but that its ROA is half
that of the industry (4 percent versus 8 percent). Because ROA is the product of net profit margin and
total asset turnover, you next examine these two ratios. Asset turnover does not appear to be a problem
because the firm's ratio is equal to the industry standard of 0.5 times. However, the firm's net profit
margin is substantially below the benchmark standard (8 percent versus 16 percent). Thus, the firm's
performance problem stems from a low profit margin.
Identifying the low profit margin as an area of concern is only a first step. Further investigation is
necessary to determine the underlying problem and its causes. The point to remember is that financial
analysis identifies areas of concern within the firm, but rarely does it tell us all we need to know.
Is Maximizing ROE an Appropriate Goal?
Throughout the book we have stressed the notion that management should make decisions that
maximize the current value of the company stock. An important question is whether maximizing the
value of ROE, as suggested by the DuPont system, is equivalent to wealth maximization. The short
answer is that the two goals are not equivalent, but some discussion is warranted.
A major shortcoming of ROE is that it does not directly consider cash flow. ROE considers earnings,
but earnings are not the same as future cash flows. Second, ROE does not consider risk. As discussed
in Chapter 1
, management and stockholders are very concerned about the degree of risk they face.
Third, ROE does not consider the size of the initial investment or the size of future cash payments. As we
stressed in Chapter 1
, the essence of any business or investment decision is this: What is the size of the
cash flows to be received, when do you expect to receive the cash flows, and how likely are you to
receive them?
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EXHIBIT 4.5 Relations in the DuPont System of Analysis for Diaz Manufacturing in 2011 ($ millions)
The diagram shows how the three key DuPont ratios are linked together and to the firm's balance sheet
and income statement. Numbers in the exhibit are in millions of dollars and represent 2011 data from
Diaz Manufacturing. The ROE of 12.67 percent differs from the 12.64 percent in Exhibit 4.3
due to
rounding.
In spite of these shortcomings, ROE analysis is widely used in business as a measure of operating
performance. Proponents of ROE analysis argue that it provides a systematic way for management to
work through the income statement and balance sheet and to identify problem areas within the firm.
Furthermore, they note that ROE and stockholder value are often highly correlated.
> BEFORE YOU GO ON
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1.
What is the purpose of the DuPont system of analysis?
2.
What is the equation for ROA in the DuPont system, and how do the factors in that equation
influence the ratio?
3.
What are the three major shortcomings of ROE?
4.5 SELECTING A BENCHMARK
How do you judge whether a ratio value is too high or too low? Is the value good or bad? We touched on
these questions several times earlier in the chapter. As we suggested, the starting point for making
these judgments is selecting an appropriate benchmark—a standard that will be the basis for
meaningful comparisons. Financial managers can gather appropriate benchmark data in three ways:
through trend, industry, and peer group analysis.
Trend Analysis
Visit the Web site of the Risk Management Association for a variety of ratio definitions and sample
financial
ratio
benchmarks
across
different
industries: http://www.rmahq.org
/RMA/RMAUniversity/ProductsandServices/RMABookstore/
StatementStudies.
Trend analysis uses history as its standard by evaluating a single firm's performance over time. This sort
of analysis allows management to determine whether a given ratio value has increased or decreased
over time and whether there has been an abrupt shift in a ratio value. An increase or decrease in a ratio
value is in itself neither good nor bad. However, a ratio value that is changing typically prompts the
financial manager to sort out the issues surrounding the change and to take any action that is
warranted.
Exhibit 4.3
shows the trends in Diaz Manufacturing's ratios. For example, the exhibit shows
that Diaz's current ratio has improved, suggesting that the company is not having a problem with
liquidity at the present time.
Industry Analysis
A second way to establish a benchmark is to conduct an industry group analysis. To do that, we identify
a group of firms that have the same product line, compete in the same market, and are about the same
size. The average ratio values for these firms will be our benchmarks. Since no two firms are identical,
deciding which firms to include in the analysis is always a judgment call. If we can construct a sample of
reasonable size, however, the average values provide defensible benchmarks.
Standard Industrial Classification (SIC) System
a numerical system developed by the U.S. Government to classify businesses according to the type of
activity they perform
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Financial ratios and other financial data for industry groups are published by a number of sources—
the U.S. Department of Commerce, Dun & Bradstreet, the Risk Management Association, and Standard
& Poor's (S&P), to name a few. One widely used system for identifying industry groups is the Standard
Industrial Classification (SIC) System
. The SIC codes are four-digit numbers established by the federal
government for statistical reporting purposes. The first two digits describe the type of business in a
broad sense (for example, firms engaged in building construction, mining of metals, manufacturing of
machinery, food stores, or banking). Diaz's two-digit code is 35, “Industrial and commercial machinery
and computer equipment.”
More than 400 companies fall into the “Industrial and commercial machinery and computer
equipment” code category. To narrow the group, we use more digits. Diaz Manufacturing's four-digit
code is 3533 (“oil and gas field machinery and equipment”), and there are only 35 firms in this category.
Among firm's within an SIC code, financial ratio data can be further categorized by asset size or by sales,
which allows for more meaningful comparisons.
North American Industry Classification System (NAICS)
a classification system for businesses introduced to refine and replace the older SIC system
In 1977, the North American Industry Classification System (NAICS)
was introduced as a new
classification system. It was intended to refine and replace the older SIC codes, but it has been slow to
catch on. Industry databases still allow you to sort data by either SIC or NAICS classifications.
You
can
find
information
about
the
SIC
and
NAICS
systems
at http://www.census.gov
/eos/www/naics/.
Although industry databases are readily available and easy to use, they are far from perfect. When
trying to find a sample of firms that are similar to your company, you may find the classifications too
broad. For example, Wal-Mart and Nordstrom have the same four-digit SIC code (5311), but they are
very different retailing firms. Another problem is that different databases may compute ratios
differently. Thus, when making benchmark comparisons, you must be careful that your calculations
match those in the database, or there could be some distortions in your findings.
Peer Group Analysis
The third way to establish benchmark information is to identify a group of firms that compete with the
company we are analyzing. Ideally, the firms are in similar lines of business, are about the same size, and
are direct competitors of the target firm. These firms form a peer group.
Once a peer group has been
identified, management can obtain their financial information and compute average ratio values against
which the firm can compare its performance.
EXHIBIT 4.6 Peer Group Ratios for Diaz Manufacturing
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Peer group analysis is one way to establish benchmarks for a firm. Ideally, a firm's peer group is made up
of firms that are its direct competitors and are of about the same size. The exhibit shows the average
financial ratios for public companies that make up the peer group for Diaz Manufacturing for 2009,
2010, and 2011.
How do we determine which firms should be in the peer group? The senior management team within
a company will know its competitors. If you're working outside the firm, you can look at the firm's
annual report and at financial analysts' reports. Both of these sources usually identify key
competitors. Exhibit 4.6
shows ratios for a five-firm peer group constructed for Diaz Manufacturing for
2009 through 2011.
We consider the peer group methodology the best way to establish a benchmark if financial data for
peer firms are publicly available. We should note, however, that comparison against a single firm is
acceptable when there is a clear market leader and we want to compare a firm's performance and other
characteristics against those of a firm considered the best. For example, Ford Motor Company may want
to compare itself directly against the automobile manufacturer which is the “best in breed” in
manufacturing productivity. It is worthwhile to compare a firm with the market leader to identify areas
of weakness as well as of possible strength.
> BEFORE YOU GO ON
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1.
In what three ways can a financial manager choose a benchmark?
2.
Explain what the SIC codes are, and discuss the pros and cons of using them in financial analysis.
4.6 USING FINANCIAL RATIOS
So far, our focus has been on the calculation of financial ratios. As you may already have concluded,
however, the most important tasks are to correctly interpret
the ratio values and to make appropriate
decisions
based on this interpretation. In this section we discuss using financial ratios in performance
analysis.
Performance Analysis of Diaz Manufacturing
Let's examine Diaz Manufacturing's performance during 2011 using the DuPont system of analysis as our
diagnostic tool and the peer group sample in Exhibit 4.6
as our benchmark. For ease of discussion, Diaz's
financial ratios and the peer group data are assembled in Exhibit 4.7
.
We start our analysis by looking at the big picture—the three key DuPont ratios for the firm and a
peer group of firms (see Exhibit 4.7
). We see that Diaz Manufacturing's ROE of 12.64 percent is below
the benchmark value of 13.07 percent, a difference of 0.43 percent, which is not good news. More
dramatically, Diaz's ROA is 3.07 percent below the peer group benchmark, which is a serious difference.
Clearly, Diaz Manufacturing has some performance problems that need to be investigated.
To determine the problems, we examine the firm's equity multiplier and ROA results in more detail.
The equity multiplier value of 2.02, versus the benchmark value of 1.40, suggests that Diaz
Manufacturing is using more leverage than the average firm in the benchmark sample. Management is
comfortable with the higher-than-average leverage. Conversations with the firm's investment banker,
however, indicate that the company's debt could become a problem if the economy deteriorated and
went into a recession.
Without the higher equity multiplier and management's willingness to bear additional risk, Diaz
Manufacturing's ROE would be much lower. To illustrate this point, suppose management reduced the
company's leverage to the peer group average equity multiplier of 1.40 (see Exhibit 4.7
). With an equity
multiplier of 1.40, the firm's ROE would be only 8.78 percent (0.0627 × 1.40 = 0.0878, or 8.78 percent);
this is 3.86 percent below the firm's current ROE of 12.64 percent and 4.29 percent below the peer
group benchmark. Thus, the use of higher leverage has, to some extent, masked the severity of the
firm's problem with ROA.
EXHIBIT 4.7 Peer Group Analysis for Diaz Manufacturing
Examining the differences between the ratios of a firm and its peer group is a good way to spot areas
that require further analysis.
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Recall that ROA equals the product of the net profit margin and total asset turnover. Diaz's net profit
margin is 3.16 percent lower than the benchmark value (7.58 − 10.74 = −3.16), and its total asset
turnover ratio is slightly below the benchmark value (0.83 versus 0.87). Thus, both ratios that comprise
ROA are below the peer group benchmark standard, but the net profit margin appears to be the larger
problem.
Turning to the asset turnover ratios shown in Exhibit 4.7
, we find that the ratios for Diaz are generally
similar to the corresponding peer group ratios. An exception is inventory turnover ratio, which is
substantially below the benchmark: 2.55 for Diaz versus 5.40 for the benchmark. Diaz's management
needs to investigate why the inventory turnover ratio is off the mark.
Because Diaz Manufacturing's net profit margin is low, we next look at the various profit margins
shown in Exhibit 4.7
to gain insight into this situation. Diaz Manufacturing's gross profit margin is 4.06
percentage points above the benchmark value (30.86 − 26.80 = 4.06), which is good news. Since gross
profit margin is a factor of sales and the cost of goods sold, we can conclude that there is no problem
with the price the firm is charging for its products or with its cost of goods sold.
Diaz's problems begin with its operating margin of 10.77 percent, which is 1.23 percentage points
below the peer group benchmark of 12.00 percent (10.77 − 12.00 = −1.23). The major controllable
expense here is selling and administrative costs, and management needs to investigate why these
expenses appear to be out of line.
In sum, the DuPont analysis of Diaz Manufacturing has identified two areas that warrant detailed
investigation by management: (1) the larger-than-average inventory (slow inventory turnover) and (2)
the above-average selling and administrative expenses. Management must now investigate each of
these areas and come up with a course of action. Management may also want to give careful
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consideration to the firm's high degree of financial leverage and whether it represents a prudent degree
of risk.
Financial ratio analysis is an excellent diagnostic tool. It helps management identify the problem areas
in the firm—the symptoms. However, it does not tell management what the causes of the problems are
or what course of action should be taken. Management must drill down into the accounting data, talk
with managers in the field, and if appropriate, talk with people outside the firm, such as suppliers, to
understand what is causing the problems and how best to fix them.
APPLICATION 4.5 LEARNING BY DOING
Ron's Jewelry Store and the Missing Data
PROBLEM:
Ron Roberts has owned and managed a profitable jewelry business in San Diego County for
the past five years. He believes his jewelry store is one of the best managed in the county, and he is
considering opening several new stores.
When Ron started the store, he supplied all the equity financing himself and financed the rest with
personal loans from friends and family members. To open more stores, Ron needs a bank loan. The bank
will want to examine his financial statements and know something about the competition he faces.
Ron has asked his brother-in-law, Dennis O'Neil, a CPA, to analyze the financials. Ron has also
gathered some financial information about a company he considers the chief competition in the San
Diego County market. The company has been in business for 25 years, has a number of stores, and is
widely admired for its owners' management skills. Dennis organizes the available information in the
following table:
Calculate the missing values for the financial data above.
APPROACH:
Use the ratio equations discussed in the text to calculate the missing financial ratios for
both Ron's store and the competitor.
SOLUTION:
Ron's jewelry store:
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EXAMPLE 4.3 DECISION MAKING
Ron's Jewelry Store and the DuPont Analysis
SITUATION:
Let's continue with our analysis of Ron's jewelry store, introduced in Learning by Doing
Application 4.5. Brother-in-law Dennis has been asked to analyze the company's financials. He decides to
use the DuPont system of analysis as a framework. He arranges the critical information as follows:
Given the above financial ratios, what recommendations should Dennis make regarding Ron's jewelry
store and its management?
DECISION:
The good news is that Ron is able to earn about the same ROE as his major competitor.
Unfortunately for Ron, it's pretty much downhill from there. Turning to the first two DuPont system
ratios, we can see that Ron's ROA of 3.75 percent is much lower than his major competitor's ROA of 8.76
percent. Ron's business is also very highly leveraged, with an equity multiplier of 3.5 times, compared
with 1.5 times for the competitor. In fact, the only reason Ron's ROE is comparable to the competitor's is
the high leverage. Ron's debt-to-equity ratio is 2.5 while the competitor's is only 0.5.
Breaking the ROA into its components, we find that Ron's asset turnover ratio is the same as the
competitor's, 1.5. However, the profitability of Ron's store is extremely poor as measured by the firm's
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net profit margin of 2.50 percent, compared with the competitor's margin of 5.84 percent. One possible
explanation is that to stimulate sales and maintain asset turnover, Ron has been selling his merchandise
at too low a price.
In summary, Ron's jewelry store is not well managed. Ron needs to either increase his net profit
margin or increase his inventory turnover to bring his ROA into line with that of his major competitor.
Ron may also need to reduce his dependence on financial leverage, but it makes sense to review interest
coverage ratios before deciding whether he should do so.
Limitations of Financial Statement Analysis
Financial statement and ratio analysis as discussed in this chapter presents two major problems. First, it
depends on accounting data based on historical costs. As we discussed in Chapter 3
, knowledgeable
financial managers would prefer to use financial statements in which all of the firm's assets and
liabilities are valued at market. Financial statements based on current market values more closely reflect
a firm's true economic condition than do statements based on historical cost.
Second, there is little theory to guide us in making judgments based on financial statement and ratio
analysis. That is why it is difficult to say a current ratio of 2.0 is good or bad or to say whether ROE or
ROA is a more important ratio. The lack of theory explains, in part, why rules of thumb are often used as
decision rules in financial statement analysis. The problem with decision rules based on experience and
“common sense” rather than theory is that they may work fine in a stable economic environment but
may fail when a significant shift takes place. For example, if you were in an economic environment with
low inflation, you could develop a set of decision rules to help manage your business. However, if the
economy became inflationary, more than likely many of your decision rules would fail.
Despite the limitations, we know that financial managers and analysts routinely use financial
statements and ratio analysis to evaluate a firm's performance and to make a variety of decisions about
the firm. These financial statements and the resulting analysis are the primary means by which financial
information is communicated both inside and outside firms. The availability of market value data is
limited for public corporations and not available for privately held firms and other entities such as
government units.
Thus, practically speaking, historical accounting information often represents the best available
information. However, times are changing. As the accounting profession becomes more comfortable
with the use of market data and as technology increases its availability and reliability and lowers its cost,
we expect to see an increase in the use of market-based financial statements.
> BEFORE YOU GO ON
1.
Explain how the DuPont identity allows us to evaluate a firm's performance.
2.
What are the limitations on traditional financial statement analysis?
3.
List some of the problems that financial analysts confront when analyzing financial statements.
SUMMARY OF Learning Objectives
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Explain the three perspectives from which financial statements can be viewed.
Financial statements can be viewed from the owners', managers', or creditors' perspective. All three
groups are ultimately interested in a firm's profitability, but each group takes a different view.
Stockholders want to know how much cash they can expect to receive for their stock, what their return
on investment will be, and how much their stock is worth in the market. Managers are concerned with
maximizing the firm's long-term value through a series of day-to-day management decisions; thus, they
need to see the impact of their decisions on the financial statements to confirm that things are going as
planned. Creditors monitor the firm's use of debt and are concerned with how much debt the firm is
using and whether the firm will have enough cash to meet its obligations.
Describe common-size financial statements, explain why they are used, and be able to prepare and
use them to analyze the historical performance of a firm.
Common-size financial statements are financial statements in which each number has been scaled by a
common measure of firm size: balance sheets are expressed as a percentage of total assets, and income
statements are expressed as a percentage of net sales. Common-size financial statements are necessary
when comparing firms that are significantly different in size. The preparation of common-size financial
statements and their use are illustrated for Diaz Manufacturing in Section 4.2.
Discuss how financial ratios facilitate financial analysis and be able to compute and use them to
analyze a firm's performance.
Financial ratios are used in financial analysis because they eliminate problems caused by comparing two
or more companies of different size, or when looking at the same company over time as the size
changes. Financial ratios can be divided into five categories: (1) Liquidity ratios measure the ability of a
company to cover its current bills. (2) Efficiency ratios tell how efficiently the firm uses its assets. (3)
Leverage ratios tell how much debt a firm has in its capital structure and whether the firm can meet its
long-term financial obligations. (4) Profitability ratios focus on the firm's earnings. Finally, (5) market
value indicators look at a company based on market data as opposed to historical data used in financial
statements. The computation and analysis of major financial ratios are presented in Section 4.3 (also see
the Summary of Key Equations that follows the Summary of Learning Objectives).
Describe the DuPont system of analysis and be able to use it to evaluate a firm's performance and
identify corrective actions that may be necessary.
The DuPont system of analysis is a diagnostic tool that uses financial ratios to assess a firm's financial
strength. Once the financial ratios are calculated and the assessment is complete, management can
focus on correcting the problems within the context of maximizing the firm's ROE. For analysis, the
DuPont system breaks ROE into three components: net profit margin, which measures operating
efficiency; total asset turnover, which measures how efficiently the firm deploys its assets; and the
equity multiplier, which measures financial leverage. A diagnostic analysis of a firm's performance using
the DuPont system is illustrated in Section 4.4.
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Explain what benchmarks are, describe how they are prepared, and discuss why they are
important in financial statement analysis.
Benchmarks are used to provide a standard for evaluating the financial performance of a firm. In
financial statement analysis, a number of benchmarks are used. Most often, benchmark comparisons
involve competitors that are roughly the same size and that offer a similar range of products. Another
form of benchmarking is time-trend analysis, which compares a firm's current financial ratios against the
same ratios from past years. Time-trend analysis tells us whether a ratio is increasing or decreasing over
time. The preparation and use of peer group benchmark data are illustrated in Section 4.6.
Identify the major limitations in using financial statement analysis.
The major limitations to financial statement and ratio analysis are the use of historical accounting data
and the lack of theory to guide the decision maker. The lack of theory explains, in part, why there are so
many rules of thumb. Though rules of thumb are useful, and they may work under certain conditions,
they may lead to poor decisions if circumstances or the economic environment have changed.
SUMMARY OF Key Equations
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Self-Study Problems
4.1
The Abercrombie Supply Company reported the following information for 2011. Prepare a commonsize income statement for the year ended June 30, 2011.
Abercrombie Supply Company Income Statement for the Fiscal Year Ended June 30, 2011 ($ thousands)
Net sales
$ 2,110,965
Cost of goods sold
1,459,455
Selling and administrative expenses
312,044
Nonrecurring expenses
27,215
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Earnings before interest, taxes, depreciation, and amortization (EBITDA)
$ 312,251
Depreciation
112,178
Earnings before interest and taxes (EBIT)
$ 200,073
Interest expense
117,587
Earnings before taxes (EBT)
$ 82,486
Taxes (35%)
28,870
Net income
$ 53,616
4.2
Prepare a common-size balance sheet from the following information for Abercrombie Supply Company.
4.3
Using the 2011 data for the Abercrombie Supply Company, calculate the following liquidity ratios:
a.
Current ratio.
b.
Quick ratio.
4.4
Refer to the balance sheet and income statement for Abercrombie Supply Company for the year ended June 30, 2011. Calculate the following ratios:
a.
Inventory turnover ratio.
b.
Days' sales outstanding.
c.
Total asset turnover.
d.
Fixed asset turnover.
e.
Total debt ratio.
f.
Debt-to-equity ratio.
g.
Times-interest-earned ratio.
h.
Cash coverage ratio.
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4.5
Refer to the balance sheet and income statement for Abercrombie Supply Company for the year ended June 30, 2011. Use the DuPont equation to calculate the return on equity (ROE). In the process, calculate the following ratios: profit margin, EBIT return on assets, return on assets, equity multiplier, and total asset turnover.
Solutions to Self-Study Problems
4.1
The common-size income statement for Abercrombie Supply Company should look like the following one:
4.2
Abercrombie Supply's common-size balance sheet is as follows:
4.3
Abercrombie Supply's current ratio and quick ratio are calculated as follows:
4.4
The ratios are calculated as shown in the following table:
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4.5
Following are the calculations for the ROE and associated ratios:
Critical Thinking Questions
4.1
What does it mean when a company's return on assets (ROA) is equal to its return on equity (ROE)?
4.2
Why is too much liquidity not a good thing?
4.3
Inventory is excluded when the quick ratio or acid-test ratio is calculated because inventory is the most difficult current asset to convert to cash without loss of value. What types of inventory are likely to be most easily converted to cash without loss of value?
4.4
What does a very high inventory turnover ratio signify?
4.5
How would one explain a low receivables turnover ratio?
4.6
What additional information does the fixed asset turnover ratio provide over the total asset turnover ratio? For which industries does it carry greater significance?
4.7
How does financial leverage help stockholders?
4.8
Why is ROE generally much higher than ROA for banks relative to other industries?
4.9
Why is the ROE a more appropriate proxy of wealth maximization for smaller firms rather than for larger ones?
4.10
Why is it not enough for an analyst to look at just the short-term and long-term debt on
a firm's balance sheet?
Questions and Problems
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4.1 Liquidity ratios:
Explain why the quick ratio or acid-test ratio is a better measure of a firm's liquidity than the current ratio.
4.2 Liquidity ratios:
Flying Penguins Corp. has total current assets of $11,845,175, current liabilities of $5,311,020, and a quick ratio of 0.89. How much inventory does it have?
4.3 Efficiency ratio:
If Newton Manufacturers has an accounts receivable turnover of 4.8 times and net sales of $7,812,379, what is its receivables?
4.4 Efficiency ratio:
Bummel and Strand Corp. has a gross profit margin of 33.7 percent, sales of $47,112,365, and inventory of $14,595,435. What is its inventory turnover ratio?
4.5 Efficiency ratio:
Sorenson Inc. has sales of $3,112,489, a gross profit margin of 23.1 percent, and inventory of $833,145. What are the company's inventory turnover ratio and days' sales in inventory?
4.6 Leverage ratios:
Breckenridge Ski Company has total assets of $422,235,811 and a debt ratio of 29.5 percent. Calculate the company's debt-to-equity ratio and equity multiplier.
4.7 Leverage ratios:
Norton Company has a debt-to-equity ratio of 1.65, ROA of 11.3 percent, and total equity of $1,322,796. What are the company's equity multiplier, debt ratio, and ROE?
4.8 DuPont equation:
The Rangoon Timber Company has the following ratios:
Sales/Total assets = 2.23; ROA = 9.69%; ROE = 16.4%
What are Rangoon's profit margin and debt ratio?
4.9 DuPont Equation:
Lemmon Enterprises has a total asset turnover of 2.1 and a net profit margin of 7.5%. If its equity multiplier is 1.90, what is the ROE for Lemmon Enterprises?
4.10 Benchmark analysis:
List the ways a company's financial manager can benchmark the company's own performance.
4.11 Benchmark analysis:
Trademark Corp.'s financial manager collected the following information for its peer group to compare its performance against that of its peers.
a.
Explain how Trademark is doing relative to its peers.
b.
How do the industry ratios help Trademark's management?
4.12 Market-value ratios:
Rockwell Jewelers has announced net earnings of $6,481,778 for this year. The company has 2,543,800 shares outstanding, and the year-end stock price is $54.21. What are the company's earnings per share and P/E ratio?
4.13 Market-value ratios:
Chisel Corporation has 3 million shares outstanding at a price per share of $3.25. If the debt-to-equity ratio is 1.7 and total book value of debt equals $12,400,000, what is the market-to-book ratio for Chisel Corporation?
4.14 Liquidity ratios:
Laurel Electronics has a quick ratio of 1.15, current liabilities of $5,311,020, and inventories of $7,121,599. What is the firm's current ratio?
4.15 Efficiency Ratio:
Lambda Corporation has current liabilities of $450,000, a quick ratio of
1.8, inventory turnover of 5.0, and a current ratio of 3.5. What is the cost of goods sold for Lambda Corporation?
4.16 Efficiency ratio:
Norwood Corp. currently has accounts receivable of $1,223,675 on net sales of $6,216,900. What are its accounts receivable turnover ratio and days' sales outstanding (DSO)?
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4.17 Efficiency ratio:
If Norwood Corp.'s management wants to reduce the DSO from that calculated in the above problem to an industry average of 56.3 days and its net sales are expected to decline by about 12 percent, what would be the new level of receivables?
4.18 Coverage ratios:
Nimitz Rental Company had depreciation expenses of $108,905, interest expenses of $78,112, and an EBIT of $1,254,338 for the year ended June 30, 2011. What are the times-interest-earned and cash coverage ratios for this company?
4.19 Leverage ratios:
Conseco, Inc., has a debt ratio of 0.56. What are the company's debt-
to-equity ratio and equity multiplier?
4.20 Profitability ratios:
Cisco Systems has total assets of $35.594 billion, total debt of $9.678 billion, and net sales of $22.045 billion. Its net profit margin for the year is 20 percent, while the operating profit margin is 30 percent. What are Cisco's net income, EBIT ROA, ROA, and ROE?
4.21 Profitability ratios:
Procter & Gamble reported the following information for its fiscal year end: On net sales of $51.407 billion, the company earned net income after taxes of $6.481 billion. It had a cost of goods sold of $25.076 billion and EBIT of $9.827 billion. What are the company's gross profit margin, operating profit margin, and net profit margin?
4.22 Profitability ratios:
Wal-Mart, Inc., has net income of $9,054,000 on net sales of $256,329,812. The company has total assets of $104,912,112 and stockholders' equity of $43,623,445. Use the extended DuPont identity to find the return on assets and return on equity for the firm.
4.23 Profitability ratios:
Xtreme Sports Innovations has disclosed the following information:
Compute the following ratios for this firm using the DuPont identity: debt-to-equity ratio,
EBIT ROA, ROA, and ROE.
4.24 Market-value ratios:
Cisco Systems had net income of $4.401 billion and, at year end, 6.735 billion shares outstanding. Calculate the earnings per share for the company.
4.25 Market-value ratios:
Use the information for Cisco Systems in the last problem. In addition, the company's EBITDA was $6.834 billion and its share price was $22.36. Compute the firm's price-earnings ratio and the price-EBITDA ratio.
4.26 DuPont equation:
Carter, Inc., a manufacturer of electrical supplies, has an ROE of 23.1
percent, a profit margin of 4.9 percent, and a total asset turnover ratio of 2.6 times. Its peer group also has an ROE of 23.1 percent but has outperformed Carter with a profit margin of 5.3 percent and a total assets turnover ratio of 3.0 times. Explain how Carter managed to achieve the same level of profitability as reflected by the ROE.
4.27 DuPont equation:
Grossman Enterprises has an equity multiplier of 2.6 times, total assets of $2,312,000, an ROE of 14.8 percent, and a total assets turnover of 2.8 times. Calculate the firm's sales and ROA.
4.28
Complete the balance sheet of Flying Roos Corporation.
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You have the following information:
4.29
For the year ended June 30, 2011, Northern Clothing Company has total assets of $87,631,181, ROA of 11.67 percent, ROE of 21.19 percent, and a profit margin of 11.59 percent. What are the company's net income and net sales? Calculate the firm's debt-to-
equity ratio.
4.30
Blackwell Automotive's balance sheet at the end of its most recent fiscal year shows the following information:
In addition, it was reported that the firm had a net income of $156,042 on sales of
$4,063,589.
a.
What are the firm's current ratio and quick ratio?
b.
Calculate the firm's days' sales outstanding, total asset turnover ratio, and fixed asset turnover ratio.
4.31
The following are the financial statements for Nederland Consumer Products Company for the fiscal
year ended September 30, 2011.
Nederland Consumer Products Company Income Statement for the Fiscal Year Ended September 30, 2011
Net sales
$51,407
Cost of products sold
25,076
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Gross margin
$26,331
Marketing, research, administrative exp.
15,746
Depreciation
758
Operating income (loss)
$ 9,827
Interest expense
477
Earnings (loss) before income taxes
$ 9,350
Income taxes
2,869
Net earnings (loss)
$ 6,481
Calculate all the ratios, for which industry figures are available below, for Nederland and
compare the firm's ratios with the industry ratios.
Ratio
Industry Average
Current ratio
2.05
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Quick ratio
0.78
Gross margin
23.9%
Net profit margin
12.3%
Debt ratio
0.23
Long-term debt to equity
0.98
Interest coverage
5.62
ROA
5.3%
ROE
18.8%
4.32
Refer to the preceding information for Nederland Consumer Products Company. Compute the firm's ratios for the following categories and briefly evaluate the company's performance using these numbers.
a.
Efficiency ratios.
b.
Asset turnover ratios.
c.
Leverage ratios.
d.
Coverage ratios.
4.33
Refer to the earlier information for Nederland Consumer Products Company. Using the DuPont identity, calculate the return on equity for Nederland, after calculating the ratios that make up the DuPont identity.
4.34
Nugent, Inc., has a gross profit margin of 31.7 percent on sales of $9,865,214 and total assets of $7,125,852. The company has a current ratio of 2.7 times, accounts receivable of $1,715,363, cash and marketable securities of $315,488, and current liabilities of $870,938.
a.
What is Nugent's total current assets?
b.
How much inventory does the firm have? What is the inventory turnover ratio?
c.
What is Nugent's days' sales outstanding?
d.
If management wants to set a target DSO of 30 days, what should Nugent's accounts receivable be?
4.35
Recreational Supplies Co. has net sales of $11,655,000, an ROE of 17.64 percent, and a total asset turnover of 2.89 times. If the firm has a debt-to-equity ratio of 1.43, what is the company's net income?
4.36
Nutmeg Houseware Inc. has an operating profit margin of 10.3 percent on revenues of $24,547,125 and total assets of $8,652,352.
a.
Find the company's total asset turnover ratio and its operating profit (EBIT).
b.
If the company's management has set a target for the total asset turnover ratio to be 3.25 next year without any change in the total assets of the company, 99
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what will have to be the new sales level for the next year? Calculate the dollar change in sales necessary and the percentage change in sales necessary.
c.
If the operating profit margin declines to 10 percent, what will be the EBIT at the new level of sales?
4.37
Modern Appliances Corporation has reported its financial results for the year ended December 31, 2011.
Modern Appliances Corporation Income Statement for the Fiscal Year Ended December 31, 2011
Net sales
$5,398,412,000
Cost of goods sold
3,432,925,255
Gross profit
$1,965,486,745
Selling, general, and administrative expenses
1,036,311,231
Depreciation
299,928,155
Operating income
$ 629,247,359
Interest expense
35,826,000
EBT
$ 593,421,359
Income taxes
163,104,554
Net earnings
$ 430,316,805
100
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Using the information from the financial statements, complete a comprehensive ratio
analysis for Modern Appliances Corporation.
a.
Calculate these liquidity ratios: current and quick ratios.
b.
Calculate these efficiency ratios: inventory turnover, accounts receivable turnover, DSO.
c.
Calculate these asset turnover ratios: total asset turnover, fixed asset turnover.
d.
Calculate these leverage ratios: total debt ratio, debt-to-equity ratio, equity multiplier.
e.
Calculate these coverage ratios: times interest earned, cash coverage.
f.
Calculate these profitability ratios: gross profit margin, net profit margin, ROA, ROE.
g.
Use the DuPont identity, and after calculating the component ratios, compute the ROE for this firm.
4.38
Common-size analysis is used in financial analysis to
a.
evaluate changes in a company's operating cycle over time.
b.
predict changes in a company's capital structure using regression analysis.
c.
compare companies of different sizes or compare a company with itself over time.
d.
restate each element in a company's financial statement as a proportion of the similar account for another company in the same industry.
4.39
The TBI Company has a number of days of inventory of 50. Therefore, the TBI Company's inventory turnover is closest to
a.
4.8 times.
b.
7.3 times.
c.
8.4 times.
d.
9.6 times.
4.40
DuPont analysis involves breaking return-on-assets ratios into their
a.
profit components.
b.
marginal and average components.
c.
operating and financing components.
d.
profit margin and turnover components.
4.41
If a company's net profit margin is −5 percent, its total asset turnover is 1.5 times, and its financial leverage ratio is 1.2 times, its return on equity is closest to
a.
−9.0 percent.
b.
−7.5 percent.
c.
−3.2 percent.
d.
1.8 percent.
Sample Test Problems
4.1
Morgan Sports Equipment Company has accounts payable of $1,221,669, cash of $677,423, inventory of $2,312,478, accounts receivable of $845,113, and net working capital
of $2,297,945. What are the company's current ratio and quick ratio?
4.2
Southwest Airlines, Inc., has total operating revenues of $6.53 million on total assets of $11.337 million. Their property, plant, and equipment, including their ground equipment and other assets, are listed at a historical cost of $11.921 million, while the accumulated 101
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depreciation and amortization amount to $3.198 million. What are the airline's total asset turnover and fixed asset turnover ratios?
4.3
Haugen Enterprises has an equity multiplier of 2.5. What is the firm's debt ratio?
4.4
Centennial Chemical Corp. has a gross profit margin of 31.4 percent on revenues of $13,144,680 and EBIT of $2,586,150. What are the company's cost of goods sold and operating profit margin?
4.5
National City Bank has 646,749,650 shares of common stock outstanding that are currently priced at $37.55 per share. If its net income is $2,780,955,000, what are its earnings per share and price-earnings ratio?
ETHICS CASE: A SAD TALE: The Demise of Arthur Andersen
©Jim Bourg/Reuters/©Corbis
In January 2002, there were five major public accounting firms: Arthur Andersen, Deloitte Touche,
KPMG, Pricewaterhouse-Coopers, and Ernst & Young. By late fall of that year, the number had been
reduced to four. Arthur Andersen became the first major public accounting firm to be found guilty of a
felony (a conviction later overturned), and as a result it virtually ceased to exist.
That such a fate could befall Andersen is especially sad given its early history. When Andersen and
Company was established in 1918, it was led by Arthur Andersen, an acknowledged man of principle,
and the company had a credo that became firmly embedded in the culture: “Think Straight and Talk
Straight.” Andersen became an industry leader partly on the basis of high ethical principles and integrity.
How did a one-time industry leader find itself in a position where it received a corporate death
penalty over ethical issues? First, the market changed. During the 1980s, a boom in mergers and
acquisitions and the emergence of information technology fueled the growth of an extremely profitable
consulting practice at Andersen. The profits from consulting contracts soon exceeded the profits from
auditing, Andersen's core business. Many of the consulting clients were also audit clients, and the firm
found that the audit relationship was an ideal bridge for selling consulting services. Soon the audit fees
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became “loss leaders” to win audits, which allowed the consultants to sell more lucrative consulting
contracts.
Tension between Audit and Consulting
At Andersen, tension between audit and consulting partners broke into open and sometimes public
warfare. At the heart of the problem was how to divide up the earnings from the consulting practice
among the two groups. The resulting conflict ended in divorce, with the consultants leaving to form their
own firm. The firm, Accenture, continues to thrive today.
Once the firm split in two, Andersen began to rebuild a consulting practice as part of the accounting
practice. Consulting continued to be a highly profitable business, and audit partners were now asked to
sell consulting services to other clients, a role that many auditors found uncomfortable.
Although the accountants were firmly in charge, the role of partners as salespersons compounded an
already existing ethical issue—that of conflict of interest. It is legally well established that the fiduciary
responsibility of a certified public accounting (CPA) firm is to the investors and creditors of the firm
being audited. CPA firms are supposed to render an opinion as to whether a firm's financial statements
are reasonably accurate and whether the firm has applied generally accepted accounting principles in a
consistent manner over time so as not to distort the financial statements. To meet their fiduciary
responsibilities, auditors must maintain independence from the firms they audit.
What might interfere with the objective judgment of the public accounting firms? One problem arises
because it is the audited companies themselves that pay the auditors' fees. Auditors might not be
completely objective when auditing a firm because they fear losing consulting business. This is an issue
that regulators and auditors have not yet solved. But another problem arises in situations where
accounting firms provide consulting services to the companies they audit. Although all of the major
accounting firms were involved in this practice to some extent, Andersen had developed an aggressive
culture for engaging partners to sell consulting services to audit clients.
Andersen's Problems Mount
The unraveling of Andersen began in the 1990s with a series of accounting scandals at Sunbeam, Waste
Management, and Colonial Realty—all firms that Andersen had audited. But scandals involving the
energy giant Enron proved to be the firm's undoing. The account was huge. In 2000 alone, Andersen
received $52 million in fees from Enron, approximately 50 percent for auditing and 50 percent for other
consulting services, especially tax services. The partner in charge of the account and his entire 100-
person team worked out of Enron's Houston office. Approximately 300 of Enron's senior and middle
managers had been Andersen employees.
Enron went bankrupt in December 2001 after large-scale accounting irregularities came to light,
prompting an investigation by the Securities and Exchange Commission (SEC). It soon became clear that
Enron's financial statements for some time had been largely the products of accounting fraud, showing
the company to be in far better financial condition than was actually the case. The inevitable question
was asked: Why hadn't the auditors called attention to Enron's questionable accounting practices? The
103
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answer was a simple one. Andersen had major conflicts of interest. Indeed, when one member of
Andersen's Professional Standards Group objected to some of Enron's accounting practices, Andersen
removed him from auditing responsibilities at Enron—in response to a request from Enron
management.
Playing Hardball and Losing
The SEC was determined to make an example of Andersen. The Justice Department began a criminal
investigation, but investigators were willing to explore some “settlement options” in return for
Andersen's cooperation. However, Andersen's senior management appeared arrogant and failed to
grasp the political mood in Congress and in the country after a series of business scandals that had
brought more than one large company to bankruptcy.
After several months of sparring with the Andersen senior management team, the Justice
Department charged Andersen with a felony offense—obstruction of justice. Andersen was found guilty
in 2002 of illegally instructing its employees to destroy documents relating to Enron, even as the
government was conducting inquiries into Enron's finances. During the trial, government lawyers argued
that by instructing its staff to “undertake an unprecedented campaign of document destruction,”
Andersen had obstructed the government's investigation.
Since a firm convicted of a felony cannot audit a publicly held company, the conviction spelled the
end for Andersen. But even before the guilty verdict, there had been a massive defection of Andersen
clients to other accounting firms. The evidence presented at trial showed a breakdown in Andersen's
internal controls, a lack of leadership, and an environment in Andersen's Houston office that fostered
recklessness and unethical behavior by some partners.
In 2005, the United States Supreme Court unanimously overturned the Andersen conviction on the
grounds that the jury was given overly broad instructions by the federal judge who presided over the
case. But by then it was too late. Most of the Andersen partners had either retired or gone to work for
former competitors, and the company had all but ceased to exist.
DISCUSSION QUESTIONS
1.
To what extent do market pressures encourage unethical behavior? Can the demise of Andersen be blamed on the fact that the market began rewarding consulting services of the kind Andersen could provide?
2.
How serious are the kinds of conflicts of interest discussed in this case? Did Sarbanes-Oxley eliminate the most serious conflicts?
3.
Was it fair for the government to destroy an entire company because of the misdeeds of some of its members, or had Andersen become such a serious offender that such an action on the part of the government was justified?
1
This calculation involves dividing total current assets by total current liabilities. We drop the word
“total” in the interest of brevity.hitbi
104
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2
The quick ratio will always be less than the current ratio for any firm that has inventory.
3
EBITDA can differ from actual cash flows because of the accounting accruals and the investment in net
working capital and fixed assets that we discussed in Chapter 3
.
105
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