Chapter Eighteen ANALYZING FINANCIAL STATEMENTS

Chapter Eighteen

ANALYZING FINANCIAL STATEMENTS

LEARNING OBJECTIVES

• • • • • •

After reading this chapter, you should be able to Explain why financial analysts use ratios to evaluate companies.

Explain liquidity and show how ratios can measure a company’s liquidity. Explain profitability and show how ratios can measure a company’s profitability. Explain solvency and show how ratios can measure a company’s solvency. Describe leverage and show how it changes returns to stockholders. Explain some limitations of ratio analysis.

The financial performance of a company is of major interest to its employees and shareholders, among others. A company’s goals are often stated in terms of financial results. For example:

Minnesota Mining & Manufacturing (3M) has stated its financial goals as follows: “We strive to maximize shareholder value through solid, profitable growth and effective use of capital. Specific financial goals are to achieve (1) at least 30 percent of sales from products introduced during the past four years; (2) growth in earnings per share of more than 10 percent a year, on average; (3) growth in economic profit exceeding earnings per share growth, and return on invested capital among the highest of industrial companies.” Walt Disney Company has stated: “The company’s primary financial objective remains 20% compound annual earnings per share growth over future five-year periods and, secondarily, steady improvement in return on equity.” Boise Cascade has stated: “We are moving rapidly to achieve fully competitive positions in all of our businesses and products and are focused on achieving our financial goals: To be profitable throughout the business cycle and to be EVA-positive over the cycle.” Sources: 3M 1997 annual report. Walt Disney Company 1997 Factbook. Boise Cascade 1997 annual report.

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2 CHAPTER

11 CHAPTER

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Analyzing Financial Statements

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Throughout this book we have stressed the importance of expectations and the ways that accounting and other information help managers form reasonable expectations. We have also used ratios among financial statement elements. Chapter 2 showed that managers often express target profits as a ratio of income to sales (return on sales). In Chapter 11 you saw that managers commonly use the ratio of income to total assets (or some other measure of return on investment) to measure divisional performance. Chapter 7 illustrated the cash squeeze that can accompany buildups of inventories and receivables, as well as how managers use ratios when developing long-term plans. This chapter addresses the analysis of financial statements, including the calculation, interpretation, and evaluation of financial ratios. Many people and organizations outside a company, such as suppliers and investors in debt or equity securities, are interested in the company’s activities. Banks that provide short-term loans, insurance companies that buy long-term bonds, brokerage firms that give (or sell) investment advice to their customers, mutual funds that buy stocks or bonds—all of these, and many other institutions, employ financial analysts to help make decisions about individual companies. Individual investors also perform financial analyses. Our approach to analyzing financial statements is that of a financial analyst, who makes recommendations to investors after studying financial statements and other sources of information about a business. Because an analyst’s recommendations can affect a company’s ability to obtain credit, sell stock, and secure new contracts, internal managers must also be aware of what concerns financial analysts.

EXPECTATIONS AND PERFORMANCE

Like a company’s managers, financial analysts base their decisions on expectations about the future. Just as managers focus on forecasts, financial analysts concentrate on what the future holds. Analysts want to know what to expect from a company—whether it will be able to pay its employees and suppliers, repay its loans, pay dividends on its stock, and expand into new areas. As with company managers, financial analysts also are concerned with the past only insofar as they can use the past as a reliable guide to the future. For example, an impressive history of growth in net income, sales, financial stability, and capable management is overshadowed if the company’s major product is determined to be harmful in some way (e.g., tobacco, leaded gasoline), or becomes illegal (e.g., asbestos, the insecticide DDT) or obsolete (e.g., early types of computers and calculators). Nevertheless, analysts assume that what has held true in the past is likely to continue unless they have information that indicates otherwise, much as managers use a cost prediction formula developed on the basis of past experience. Hence, both analysts and a company’s managers must be continually alert for signs that the future will differ from the past. In addition to focusing on the future, managers and financial analysts use many of the same analytical approaches.

METHODS OF ANALYSIS

Financial analysis consists of a number of interrelated activities. Among the most important are considerations of ratios and trends and the comparison of ratios

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and trends against some norms. (A norm is a standard for comparison, which could be an average value for a particular industry or for all companies in the economy.) Trends are of interest as clues to the future. Ratios can take three different forms. Some ratios are comparisons of an income statement element with another income statement element. Other ratios are comparisons of balance sheet elements with other balance sheet elements. Still others compare an income statement element such as sales or cost of goods sold, with a balance sheet element such as accounts receivable or total assets. In this last set of ratios we could use either average assets or assets at year end. Analysts use both versions, depending on circumstances and preferences. We shall illustrate this point a few times as we proceed through the ratios. You should keep in mind that no one version is “right” and another “wrong.” Analysts simply have differing views. AREAS OF ANALYSIS

Different types of investors are interested in different aspects of a company. Shortterm creditors, such as suppliers and banks considering loans of relatively short duration (90 days or six months), are concerned primarily with a company’s short-term prospects. They want to know whether a company will be able to pay its obligations in the near future. Banks, insurance companies, pension funds, and other investors considering relatively long-term commitments (e.g., ten-year loans) cannot ignore short-term prospects, but are more concerned with the longterm outlook. Even if such investors are satisfied that a company has no shortterm problems, they want to be reasonably sure that it has good prospects for long-term financial stability and can be expected to repay its longer-term loans with interest. Stockholders, current and potential, are also interested in both the short-term and long-term prospects of the company. But their interest goes beyond the company’s ability to repay loans and make interest payments. Their concern is with profitability—the ability to earn satisfactory profits and pay dividends—and the likelihood that the market price of the stock will increase. We have divided the discussion of these aspects of a company’s prospects into three major areas: liquidity, solvency, and profitability. For the most part we work with ratios. Apart from expressing relationships between two factors, ratios are useful because they facilitate comparisons among companies of different sizes. ILLUSTRATION

We shall use the comparative financial statements and the additional financial information about Burke Company shown in Exhibit 18-1. The analysis has actually begun in the exhibit because it shows the percentages of sales for each item on the income statement and the percentage of total assets or total equities for each balance sheet item. These percentage statements, or common-size statements, can help an analyst to spot trends. Two of the more important percentages on the income statement are the gross profit ratio, which is gross profit divided by sales, and return on sales (ROS), which is net income divided by sales. These ratios for Burke in 20X2 are 38.5 and 7.9 percent, respectively. The gross profit ratio improved in 20X2 over 20X1, but ROS declined.

Chapter Eighteen

Exhibit 18-1

Analyzing Financial Statements

Burke Company, Balance Sheets as of December 31 20X2 Dollars

20X1 Percent

Dollars

Percent

Current assets: Cash

$

Accounts receivable, net Inventory

80,000

5.2%

180,000

11.6

$

50,000

3.6%

120,000

8.7

190,000

12.2

230,000

16.7

Total current assets

$ 450,000

29.0

$ 400,000

29.0

Plant and equipment—cost

$1,350,000

87.1

$1,150,000

Accumulated depreciation Net plant and equipment

(340,000) $1,010,000 90,000

(21.9) 65.2 5.8

(250,000)

83.3 (18.1)

$ 900,000 $

65.2

Other assets

$

80,000

5.8

Total assets

$1,550,000

100.0%

$1,380,000

100.0%

$ 110,000

7.1%

$ 105,000

7.6%

Current liabilities: Accounts payable Accrued expenses Total current liabilities Long-term debt

40,000

2.6

15,000

1.1

$ 150,000

9.7

$ 120,000

8.7

600,000

38.7

490,000

35.5

$ 750,000

48.4

$ 610,000

44.2

$ 220,000

14.2

$ 220,000

15.9

Paid-in capital

350,000

22.6

350,000

25.4

Retained earnings

230,000

14.8

200,000

14.5

Total liabilities Common stock, 22,000 shares

Total stockholders’ equity

$ 800,000

51.6

$ 770,000

55.8

Total equities

$1,550,000

100.0%

$1,380,000

100.0%

Burke Company, Income Statements for the Years Ended December 31 20X2 Sales Cost of goods sold Gross profit Operating expensesa

20X1

Dollars

Percent

Dollars

Percent

$1,300,000

100.0%

$1,080,000

100.0%

800,000

61.5

670,000

62.0

$ 500,000

38.5

$ 410,000

38.0

280,000

21.6

210,000

19.4

$ 220,000

16.9

$ 200,000

18.6

Income before interest and taxes Interest expense Income before taxes Income taxes at 40% rate Net income

48,000

3.7

42,000

3.9

$ 172,000

13.2

$ 158,000

14.7

68,800 $ 103,200

a Including depreciation of $90,000 in 20X2 and $75,000 in 20X1

5.3 7.9%

$

63,200

5.9

94,800

8.8%

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Both financial analysts and internal managers are interested in ROS and the gross profit ratio because these ratios indicate how valuable a dollar of sales is to the company. (These ratios are not the same as the contribution margin ratio, but they do give a rough idea of the profit/sales relationship.) A relatively low ROS, combined with a gross profit ratio that is normal for the industry, could indicate that operating expenses are higher than those of other companies. Similarly, a decline in ROS or the gross profit ratio could suggest weakening prices, which could be very serious. Stocks of many manufacturers of computer chips fall sharply because of concerns over softening prices, reflected in falling margins. 3Com stated that its margins declined in late 1997 due to reducing selling prices by as much as 40 percent in order to remain competitive. As we mention several times in this chapter, ratios provide clues or indicators, but they do not tell you whether a company’s managers are acting wisely or unwisely. Balance sheet ratios show whether the proportions of particular assets or liabilities are increasing or decreasing, and whether they are within reasonable bounds. We explore balance sheet ratios in more detail later in the chapter.

LIQUIDITY

Liquidity is a company’s ability to meet obligations due in the near future. The more liquid the company, the more likely it will be able to pay its employees, suppliers, and holders of its short-term notes payable. A company with excellent long-term prospects could fail to realize them because it was forced into bankruptcy when it could not pay its debts in the near term. Hence, while liquidity is most important to short-term creditors, it also interests long-term creditors and stockholders. WORKING CAPITAL AND THE CURRENT RATIO

Working capital, the difference between current assets and current liabilities, is a very rough measure of liquidity. Burke had the following amounts of working capital at the end of 20X1 and 20X2. 20X2

20X1

Current assets Current liabilities

$450,000 150,000

$400,000 120,000

Working capital

$300,000

$280,000

Working capital is positive and has increased. But this does not necessarily mean that Burke has adequate liquidity or became more liquid. Most analysts consider changes in working capital as only a very rough indication of changes in liquidity and supplement their analysis with several other calculations. Working capital is stated in absolute dollar terms and hence is greatly influenced by the size of the company. The current ratio is a measure of relative liquidity that takes into account differences in absolute size. It is used to compare companies with different total current assets and liabilities as well as to compare the same company’s liquidity from year to year.

Chapter Eighteen

Current ratio =

Analyzing Financial Statements

799

current assets current liabilities

Burke has current ratios of 3.33 to 1 in 20X1 ($400,000/$120,000) and 3 to 1 in 20X2 ($450,000/$150,000). On the basis of the current ratio, we would say that the company seemed to be less liquid at the end of 20X2. With good reason we said “seemed to be less liquid.” One major problem that arises with any ratio, but especially the current ratio, is that of composition. The composition problem arises when one uses a total, such as total current assets (or current liabilities), that might mask information about the individual components. How soon will the current assets be converted into cash so that they can be used to pay current liabilities? How soon are the current liabilities due for payment? You already know that current assets normally are listed in order of liquidity from cash, the most liquid, to prepaid expenses. The analyst obtains a general idea of the magnitude of the composition problem by reviewing the common-size balance sheet to see how much of current assets consists of relatively liquid items. QUICK RATIO (ACID-TEST RATIO)

The quick ratio, or acid-test ratio, is cash plus marketable securities plus accounts receivable divided by current liabilities. It is similar to the current ratio, but includes only those assets that are cash or “near cash” (called quick assets). Hence, the ratio gives a stricter indication of short-term debt-paying ability than does the current ratio. Quick ratio =

cash + marketable securities + accounts receivable current liabilities

Burke had no marketable securities at the end of either year, so its quick ratios are as follows: 20X1

$50,000 + $120,000 = $120,000

1.42

20X2

$80,000 + $180,000 = $150,000

1.73

Burke seems to have increased its liquidity because its quick ratio increased. We could say that the company was better able to meet current liabilities at the end of 20X2; but we would still like to know how soon its current liabilities have to be paid and how rapidly it can expect to turn its receivables and inventory into cash. The next section presents ratios that measure the liquidity of current assets. WORKING CAPITAL ACTIVITY RATIOS

Two commonly used ratios provide information about the time within which a company should realize cash from its receivables and inventories. And, although we cannot tell the time within which the company must pay its various current liabilities simply by examining the financial statements, one commonly used ratio offers some insight into the company’s bill-paying practices.

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Accounts Receivable Turnover

Accounts receivable turnover measures how rapidly a company collects its receivables; in general, the higher the turnover the better. Accounts receivable turnover

sales accounts receivable

=

Average receivables is defined as the beginning accounts receivable balance plus the ending balance, divided by 2. The year-end balance also may be used. The simple averaging procedure is satisfactory so long as there are no extremely high or low points during the year (including the end of the year). If a company’s receivables fluctuate widely, using a monthly average for receivables is better. Again, many analysts simply use the year-end value. Some analysts prefer to use credit sales for the calculation, instead of total sales, but outsiders typically cannot determine how much of total sales are on credit or for cash. Internal managers can determine credit sales and thus can compute the turnover of credit sales, as well as of total sales. Because we do not have the beginning balance for 20X1, we can only calculate the turnover of average receivables for 20X2 for Burke Company. (We can compute 20X1 turnover using the end of year value.) $1,300,000 = ($120,000 + $180,000)/2

$1,300,000 = $150,000

8.67 times

The 20X1 turnover using the ending balance is $1,080,000/$120,000 =

9 times

Some analysts make a related calculation called number of days’ sales in accounts receivable. This figure indicates the average age of ending accounts receivable. Days’ sales in accounts receivable

=

ending accounts receivable average daily sales

Average daily sales is simply sales for the year divided by 365. For Burke Company, we have average daily sales of about $2,959 ($1,080,000/365) for 20X1 and about $3,562 ($1,300,000/365) for 20X2. Hence, days’ sales in accounts receivable are 20X1

$120,000 = $2,959

41 days

20X2

$180,000 = $3,563

51 days

On average, then, Burke’s accounts receivable were 41 days old at the end of 20X1 and 51 days old at the end of 20X2. The collection period has lengthened considerably in one year, but the period must be interpreted in light of the credit terms offered to customers. The faster customers pay, the better, but there are always trade-offs. If a company loses sales because of tight credit policies, the advantage of faster collection might be more than offset by the loss of profits from lower total

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sales. The increase in the average collection period might well be the result of a management decision to offer more liberal terms to stimulate sales. Inventory Turnover

The type of analysis discussed in connection with receivables also applies to the company’s inventory. Inventory turnover is calculated as follows: Inventory turnover =

cost of goods sold inventory

Again, most analysts use an average value, the sum of the beginning and ending balances divided by 2, unless the company has much higher and lower inventories for significant portions of the year because of seasonal business. It is then better to use monthly figures to determine the average. And, again, many analysts simply use the year-end value for inventory. Burke’s inventory turnover for 20X2 is about 3.8 times, calculated as follows: $800,000 ($230,000 + $190,000)/2

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6 CHAPTER

9

=

$800,000 $210,000

=

3.8 times

Using only the year-end inventory for 20X1, turnover is 2.9 times ($670,000/$230,000). Inventory turnover indicates the efficiency with which a company uses its inventory. High inventory turnover is critical for many businesses, especially those that sell at a relatively low markup (ratio of gross profit to sales) and depend on high sales volumes to earn satisfactory profits. For example, discount stores and food stores rely on quick turnover for profitability. Companies with very high markups, such as jewelry stores, do not need such rapid turnovers to be profitable. As discussed in Chapters 1, 6, and 9, maintaining inventory can be very expensive. Some costs—insurance, personal property taxes, interest on the funds tied up in inventory, and obsolescence—can be very high. Therefore, managers prefer to keep inventory as low as possible. The problem is that if inventory is too low, particularly in retail stores, sales might be lost because customers cannot find what they want. Analysts sometimes calculate the number of days’ sales in inventory, which is a measure of the supply that the company maintains. Days’ sales in inventory =

ending inventory average daily cost of goods sold

Average daily cost of goods sold is simply cost of goods sold for the year divided by 365. For Burke, this is $1,836 ($670,000/365) for 20X1 and $2,192 ($800,000/365) for 20X2. Days’ sales in inventory are as follows: 20X1

$230,000 $1,836

=

125 days

20X2

$190,000 $2,192

=

87 days

The decline in days’ sales in Burke’s inventory could indicate a deliberate change in inventory policy, or perhaps just a temporary reduction of inventory because

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of heavier than expected sales near the end of the year. The accompanying Insight illustrates how Dell Computer Corporation manages working capital to achieve a strategic advantage. As you may remember from your study of financial accounting, generally accepted accounting principles (GAAP) allow several formats for the income statement. Some formats do not show cost of goods sold, so that an outside analyst cannot compute inventory turnover using the approach just presented. In such cases, the analyst will use sales as a substitute for cost of goods sold, even though sales and inventory are not measured in the same way. (Sales is measured in selling prices, while inventory is measured in cost prices.) The inventory turnover so derived is overstated—a unit costing $1 and sold for $2 will reflect two inventory turnovers when only one unit has been sold. If analysts recognize the overstatement in the calculation, they will not be misled by the results. PROFITABILITY

Profitability can be measured in absolute dollar terms, such as net income, or by ratios. The most commonly used measures of profitability fall under the general

IN

SIGHT Working Capital Ratios at Dell Computer

Dell Computer Corporation’s business strategy is to sell computers to corpora-

tions and consumers through a direct sales approach. This allows Dell to carry little or no finished goods inventory and to use the latest components. In the computer industry, using the latest components also provides the highest profit margins. It also protects the company against price changes in components. The company focuses on the cash conversion cycle, which consists of inventory, payables, receivables, and cash flow from operations. A recent annual report presented the following ratios:

Days of Sales in Accounts Receivable Days of Supply in Inventory Days in Accounts Payable

1998

1997

1996

36 7 51

37 13 54

42 31 33

In a business where inventory prices drop by 1 percent a week, inventory is risk. While Dell had 13 days of inventory in 1997, a typical competitor that did not sell directly had 30, with another 40 in the distribution channel. “That’s a difference of 58 days,” Mr. Dell said. “In 58 days, the cost of materials will decline about 6 percent.”

Sources: Dell Computer Corporation 1998 annual report. Andy Serwer, “Michael Dell Rocks,” Fortune, May 11, 1998, 58–70. Lawrence Fisher, “Inside Dell Computer Corporation: Managing Working Capital,” Strategy and Business, First Quarter, 1998, 68–75.

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Analyzing Financial Statements

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11

heading of return on investment (ROI). As described in Chapter 11, ROI is actually a family of ratios having the general form Return on investment =

income investment

External investors, especially stockholders and potential stockholders, are interested in the return that they can expect from their investments. A company’s managers want to earn satisfactory returns on the investments that they control. As a practical matter, then, different analysts and managers will define both income and investment differently when trying to measure the same basic relationships. In this section, we present some of the most often used alternative ways of looking at this basic relationship of accomplishment (return, income) to effort (investment). RETURN ON ASSETS (ROA)

ROA measures operating efficiency—how well managers have used the assets under their control to generate income. The following ratio is one way to make the calculation. Return on assets =

net income + interest + income taxes total assets

The familiar alternatives, averages or year-end values, apply here as well. For Burke, ROA was about 15 percent for 20X2, calculated as follows: $103,200 + $48,000 + $68,800 ($1,380,000 + $1,550,000)/2

=

$220,000 $1,465,000

=

15.0%

Adding interest and income taxes back to net income is equivalent to using income before interest and income taxes. Remember that we are concerned with operations: Interest and, to some extent, income taxes depend on how the company finances its assets—how much debt it uses. Moreover, income taxes are affected by many matters not related to operations, which is another reason for adding them back. (Some of these nonoperating factors are the company’s investments in securities and its use of tax benefits such as percentage depletion.) Some analysts add back only interest; others add back only the after-tax effect of interest. There are arguments to support several measures of the numerator in the ROA calculation. Choosing one alternative over another is a matter of both personal preference and of the particular objective. Some analysts use end-of-year assets in the denominator, some use beginningof-year amounts, and still others use total assets minus current liabilities. (Analysts in the latter group argue that current liabilities are operating sources, rather than financing sources.) In this chapter, we use average total assets, or total year-end assets, with no consideration of current liabilities, but we caution you that this is a matter of choice and preference. Both internal and external analysts can obtain the information for this ratio directly from publicly available financial statements, and can make direct comparisons with companies in the same industry. RETURN ON COMMON EQUITY (ROE)

ROA is a measure of operating efficiency. Common stockholders are also concerned with the return on their investment, which is affected not only by opera-

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tions but also by the amount of debt and preferred stock in the company’s capital structure. ROE is computed as follows. Return on common equity

=

net income – dividends on preferred stock common stockholders’ equity

If there is preferred stock, preferred dividends must be subtracted from net income in the numerator, and the amount of total stockholders’ equity attributable to preferred stock is subtracted in the denominator to obtain common stockholders’ equity. Burke Company has no preferred stock, but it does have debt. ROE for Burke in 20X2 is a bit over 13 percent. $103,200 ($770,000 + $800,000)/2

=

$103,200 $785,000

=

13.1%

Notice that Burke’s ROE is less than its ROA. If a company finances its assets solely with common stock, such a relationship will hold between ROE and ROA because ROE is computed using after-tax income. But debt holders do not participate in the earnings of the company; they receive a stipulated, constant amount of interest. Hence, the company can increase its ROE if it uses debt, provided that ROA is greater than the interest rate it must pay to debt holders. This method of using debt (or preferred stock) to increase ROE is called leverage or trading on the equity (sometimes financial leverage). Leverage increases both risk and the potential for greater return. THE EFFECTS OF LEVERAGE

Suppose that a company with a 40 percent tax rate requires total assets of $1,000,000 to earn $180,000 per year before interest and income taxes, for an ROA of 18 percent. Three possible financing alternatives are (1) all common stock, (2) $400,000 common stock and $600,000 in 7 percent bonds (interest expense of $42,000), and (3) $400,000 in common stock and $600,000 in 8 percent preferred stock (dividends of $48,000). The following schedule shows the differing effects of the three alternatives on ROE. (1)

(2)

All Common Stock

Debt and Common Stock

(3) Preferred Stock and Common Stock

Income before interest and taxes Interest expense at 7%

$ 180,000 0

$180,000 42,000

$180,000 0

Income before taxes Income taxes at 40%

$ 180,000 72,000

$138,000 55,200

$180,000 72,000

Net income Less preferred stock dividends

$ 108,000 0

$ 82,800 0

$108,000 48,000

Earnings available for common stock Divided by common equity invested

$ 108,000 1,000,000

$ 82,800 400,000

$ 60,000 400,000

10.8%

20.7%

15.0%

Equals return on common equity

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Note that dividends on preferred stock must be subtracted from net income to reach earnings available for common stockholders (because the claim of preferred stockholders on company earnings comes before the claim of common stockholders). Note also that, although the plans that include debt or preferred stock both result in lower earnings available for common equity, both produce a higher ROE than the company would achieve if it used all common equity. That is, these two plans provide the benefits of leverage. However, leverage works both ways. It is good for the common stockholder when earnings are high and bad when they are low. If in one year the company earns only $60,000 before interest and taxes, it has the following results. (1) All Common

(2) $600,000 Debt

(3) $600,000 Preferred

Income before interest and taxes Interest expense at 7%

$

60,000 0

$ 60,000 42,000

$ 60,000 0

Income before taxes Income taxes at 40%

$

60,000 24,000

$ 18,000 7,200

$ 60,000 24,000

Net income Less preferred stock dividends

$

36,000 0

$ 10,800 0

$ 36,000 42,000

Earnings available for common stock Divided by common equity invested

$

36,000 1,000,000

$ 10,800 400,000

$ (6,000) 400,000

3.6%

2.7%

Equals return on common equity

negative

As you can see, ROE is highest if all common equity is used, but the return is very low. Companies having relatively stable revenues and expenses, such as public utilities, can use considerable leverage. Leverage is very risky for companies in cyclical industries such as automobile and aircraft manufacturing, and construction, where income fluctuates greatly from year to year. A couple of bad years in a row could bring a heavily leveraged company into bankruptcy. During the 1980s, leverage was so important in the acquisition of entire companies that the term leveraged buyout (LBO) became a standard part of financial discussions. Often such acquisitions were financed with high-yield bonds, called junk bonds because of their high risk. EARNINGS PER SHARE (EPS)

Investors in common stock are less concerned with a company’s total income than with their share of that income as expressed by the company’s earnings per share (EPS). EPS is the most widely cited statistic in the financial press, the business section of newspapers, and recommendations by brokerage firms and other investment advisers. In simple cases, EPS is calculated as follows: Earnings per share (EPS) =

net income – dividends on preferred stock weighted average common shares outstanding

The weighted average of common shares outstanding is the best measure of the shares outstanding throughout the period when the income is earned. If Burke has 22,000 shares outstanding all through 20X1 and 20X2, as well as at the ends of those years, its EPS figures are

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20X1

$94,800 – $0 22,000

=

$94,800 22,000

= $4.31

20X2

$103,200 – $0 22,000

=

$103,200 22,000

= $4.69

EPS in 20X2 was $0.38 higher than in 20X1. This is an 8.8 percent growth rate, which we calculate as follows: Growth rate of EPS

=

EPS current year – EPS prior year EPS prior year

The greater the growth that investors expect, the more they are willing to pay for the common stock. Of course, an increase in EPS from one year to the next does not always mean that the company is growing; it might simply reflect a rebound from a particularly poor year. EPS could also increase (or decrease) because of an unusual event that is unlikely to recur frequently. (Financial accounting refers to such events as extraordinary items.) Many analysts compare EPS numbers without the effects of extraordinary items and other one-time events such as the discontinuance of a major segment of the business or a change in accounting principle used to prepare financial statements, such as a change from FIFO to LIFO. GAAP accommodates that practice by requiring the reporting of an EPS number before extraordinary items, gains or losses on discontinued operations, and changes in accounting principle. In any case, growth rates should be calculated over a number of years, rather than for a single year as we have done here. The accompanying Insight explores the growth rates of selected companies. Some companies issue convertible securities, bonds and preferred stock that can be converted into common stock at the option of the owner. Conversion poses the problem of potential dilution (decreases) in EPS, because earnings have to be spread over a greater number of shares.1 Calculating EPS when dilution is possible can be extremely complex. We shall show a single, relatively simple, illustration. Assume that a company has net income of $200,000, 80,000 common shares outstanding, and an issue of convertible preferred stock. The preferred stock pays dividends of $20,000 and is convertible into 30,000 common shares. Using the basic formula, EPS is $2.25. $200,000 – $20,000 $180,000 = 80,000 80,000

=

$2.25

The company will show the $2.25 as basic earnings per share on the income statement. Then the income statement will report another EPS number, called diluted earnings per share. Diluted EPS is a pro forma calculation that shows what EPS would have been if convertible securities had actually been converted into common stock at the beginning of the year. Had the conversion occurred, there would have been no preferred dividends, but an additional 30,000 common shares would have been outstanding for the entire year. We calculate diluted EPS by adding back the preferred dividends on the convertible stock to the $180,000 earnings available for common stock and adding 30,000 shares to the denominator. 1 The computation of EPS is governed by Statement of Financial Accounting Standards No. 128 (Stamford, CT: Financial Accounting Standards Board, 1997).

Chapter Eighteen

IN

Analyzing Financial Statements

807

SIGHT High-Growth Companies

Many investors, called growth investors, seek out stocks with rapidly increasing profits, and such stocks can be very volatile. Fortune magazine publishes an annual listing of America’s fastest growing companies. Some of these companies will be stellar investments (Dell Computer’s stock price grew from a stockadjusted 1990 price of $0.23 to a 1998 high of $128.63, a 55,826 percent gain). Other companies on this list will be losers. The challenge of investing in growth stocks is to be able to tell which stock will be in which group. A sampling of the 1998 list is as follows: Average EPS growth (3-year average)

Annual revenue growth

Estimated P/E

394% 227% 113% 90%

36% 55% 175% 53%

10 49 13 57

Noble Drilling Vitesse Semiconductor Rainforest Café Dell Computer

Source: Fortune, September 28, 1998.

$180,000 + $20,000 80,000 + 30,000

=

$200,000 110,000

=

$1.82 diluted EPS

PRICE-EARNINGS RATIO (PE)

The PE ratio is the ratio of the market price of a share of common stock to its EPS. The ratio indicates the amount investors are paying to buy a dollar of earnings. PE ratios of high-growth potential companies are often very high; those of lowgrowth potential or declining companies tend to be low. Assume that Burke’s common stock sold at $60 per share at the end of 20X1 and $70 at the end of 20X2. The PE ratios are Price-earnings ratio

=

market price per share earnings per share

20X1

=

$60.00 = $4.31

13.9

20X2

=

$70.00 = $4.69

14.9

The increase in the PE ratio from 20X1 to 20X2 could have happened because EPS had been growing rather slowly until 20X2 and investors believed the growth rate would increase in the future. Such a situation justifies a higher PE ratio. Or per-

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haps PE ratios throughout the economy increased because of good economic news and expectations of good business conditions. DIVIDEND YIELD AND PAYOUT RATIO

We have been viewing earnings available for common stockholders as the major return accruing to owners of common stock. But investors do not “get” EPS. They receive dividends and, they hope, increases in the market value of their shares. The dividend yield is a measure of the current cash income that an investor can obtain per dollar of investment. Dividend yield =

dividend per share market price per share

Burke declared and paid dividends of $63,000 in 20X1 and $73,200 in 20X2 on 22,000 shares, giving dividends per share of $2.86 and $3.33 for 20X1 and 20X2, respectively. Given per-share market prices of $60 and $70 at the ends of 20X1 and 20X2, dividend yields are 20X1

$2.86 $60.00

=

4.77%

20X2

$3.33 $70.00

=

4.76%

The payout ratio is the ratio of dividends per share to EPS. For Burke, the payout ratio in 20X2 is 71 percent ($3.33/$4.69) and in 20X1 was 66 percent ($2.86/$4.31). In general, companies with high growth rates have relatively low dividend yields and payout ratios. Such companies are investing the cash they could use for dividends. Investors who favor high-growth companies are not looking for dividends so much as for increases in the market price of the common stock. Because such hoped-for increases might or might not occur, investing in high-growth companies is generally riskier than investing in companies that pay relatively high, stable dividends. ECONOMIC VALUE ADDED (EVA) CHAPTER

11

Chapter 11 referred to EVA in the context of divisional performance evaluation and compared it with residual income. The proponents of EVA argue that it is the best measure of the success of a company as a whole. EVA is computed as EVA

=

After-tax operating income –

(cost of capital ×

investment)

After-tax operating income is income before interest and taxes multiplied by one minus the tax rate. EVA proponents define investment differently from GAAP. Some explanations of EVA give investment as total assets less current liabilities, plus expenditures made for long-term purposes. Expenditures for research and development and for employee training are common examples. They advocate amortizing such investments over five years. Suppose Burke’s cost of capital is 9 percent and that it has no investments we need to add back. Its EVA for 20X2 is

Chapter Eighteen

EVA = = =

$220,000 $132,000 $6,000

Analyzing Financial Statements

809

× (1 – 40%) – [9% × ($1,550,000 – $150,000)] – 9% × $1,400,000

The $6,000 EVA says that Burke is covering its cost of capital and providing additional economic value to its shareholders. The accompanying Insight illustrates how companies set financial goals using EVA. SOLVENCY

Solvency refers to long-term safety, the likelihood that the company will be able to pay its long-term liabilities. Solvency is similar to liquidity but has a much longer time horizon. Both long-term creditors and stockholders are interested in solvency—long-term creditors because of a concern about receiving interest payments and a return of principal, stockholders because they cannot receive dividends and benefit from increased market prices unless the company survives. DEBT RATIO

One common measure of solvency is the debt ratio, which is calculated as shown on the following page.

IN

SIGHT Economic Value Added Goals at Champion International

“When we announced a new strategic direction for Champion on October 8, 1997, we committed the company to a goal of maximizing total shareholder return. To do this, we will focus on those businesses that have the greatest opportunity for us to earn an economic profit; we will significantly improve our profitability; and we will exercise strong financial discipline in all our spending. Improving the way we serve our customers will help us achieve a sustainable competitive advantage. In the course of implementing this new strategic direction, we will help to build a different Champion. Our governing objective is clear—to maximize total shareholder return. To accomplish this objective, we must create economic profit in all of our businesses by earning at a level that is in excess of our capital charge. Our ambitious goal is to earn an 11 percent return on capital employed and perform in the top quartile of our industry. Incentive compensation for key managers has been tied to shareholder return through a performance share plan. This plan will pay out only if, at any time within three years from inception, the total return to our shareholders has increased at a rate that is equivalent to approximately 15 percent per annum compounded for three years.”

Source: Letter to Shareholders, 1997 annual report.

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Debt ratio =

total liabilities total assets

This ratio measures the proportion of debt in a company’s capital structure. It is also called the debt-to-assets ratio. As with other ratios, variations provide much the same information. For example, some analysts calculate a debt-to-equity ratio, dividing total liabilities by stockholders’ equity; others calculate a ratio of longterm liabilities to total assets or of long-term liabilities to long-lived assets, such as property, plant, and equipment. All of these variations have the same basic objective: to determine the company’s degree of debt. The higher the proportion of debt in the capital structure, the riskier the company. Companies in different industries can handle different percentages of debt. For example, public utilities typically have very high percentages of debt because they have stable cash flows, manufacturers somewhat lower. The debt ratios for Burke Company for 20X1 and 20X2 are 20X1

=

$610,000 $1,380,000

=

44.2%

20X2

=

$750,000 $1,550,000

=

48.4%

Notice that if we subtract the debt ratio from 100 percent, we get the proportion of stockholders’ equity in the capital structure. This is usually called the equity ratio. Like the debt ratio, it is a way of measuring solvency, but from a different standpoint. Burke’s debt ratio increased from 20X1 to 20X2, but we cannot tell whether it is near a dangerous level without knowing a good deal more. We can obtain some additional information by calculating the burden that interest expense places on the company. TIMES INTEREST EARNED

Times interest earned, or interest coverage, measures the extent to which operations cover interest expense. The higher the ratio, the more likely the company will be able to continue meeting the interest payments. Times interest earned =

income before interest and taxes interest expense

Burke had interest coverage of 4.8 times in 20X1, but slipped to 4.6 times in 20X2. 20X1

$200,000 $42,000

=

4.8 times

20X2

$220,000 $48,000

=

4.6 times

We use income before interest and taxes because interest is a tax-deductible expense. Some analysts also add depreciation in the numerator. Reasoning that depreciation does not require cash payments, these analysts believe that the numerator in their ratio approximates the total amount of cash available to pay interest.

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Analyzing Financial Statements

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CASH FLOW TO TOTAL DEBT

A classic study of ratios computed for actual companies showed that the single best ratio for predicting a company’s failure was the ratio of cash flow to total debt.2 In that study, cash flow was defined as net income plus depreciation, amortization, and depletion, and total debt was defined as total liabilities plus preferred stock. Cash flow to total debt =

net income + depreciation + amortization + depletion total liabilities + preferred stock

Burke has no amortization or depletion and no preferred stock. Therefore, the values of the ratio are 20X1

$94,800 + $75,000 $610,000

$169,800 $610,000

=

27.8%

20X2

$103,200 + $90,000 $193,200 = $750,000 $750,000

=

25.8%

=

The research study drawing attention to this ratio was conducted before companies were required to provide a cash flow statement as part of the financial statement package. Using the operating cash flow taken directly from Burke’s cash flow statement, the ratios are 20X1

$177,600 $610,000

=

29.1%

20X2

$203,200 $750,000

=

27.1%

Though both versions of this solvency ratio show a decline, the decline does not seem serious. Nevertheless, comparison of the ratio with the industry average might indicate a potential problem. Other uses of cash flow ratios have become popular, especially now that GAAP requires virtually every publicly traded company to publish its cash flow statement. A number of different forms of cash flow ratios can be computed.3 Analysts use ratios to assess the adequacy of a company’s cash flow for financing operations and its growth. The accompanying Insight describes how cash ratios can provide information other balance sheet ratios cannot.

RATIOS AND EVALUATION

Calculating ratios for the current year is only the starting point in analyzing a company’s operations and prospects. Comparisons are critical and many factors besides the magnitudes of the ratios must be considered. 2 See William H. Beaver, “Financial Ratios as Predictors of Failure,” Empirical Research in Accounting, Selected Studies, 1966, Journal of Accounting Research, 1967, 71–111. 3 For an excellent discussion of cash flow ratios, see John Mills and Jeanne Yamamura, “The Power of Cash Flow Ratios,” Journal of Accountancy, October 1998, 53–61.

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Special Topics

SIGHT Cash Flow Ratios

Boomtown was a Nevada casino company that went public in 1992. By 1996,

Boomtown had four properties in three different states. Total assets increased over this time period from $56 million in 1992 to $206 million in 1996. The current ratio and the quick ratio for the 5-year period would lead an analyst to believe Boomtown was a strong company financially. Cash flow ratios pointed out severe problems. Boomtown’s growth was funded almost exclusively through outside funds. In 1997, Boomtown ran out of cash and was acquired by Hollywood Park, Inc.

Source: John Mills and Jeanne Yamamura, “Case Study: Running a Casino Is Not a Game,” Journal of Accountancy, October 1998, 54–55.

Analysts should compare ratios with those from prior years, evaluate trends, and explore related ratios. (Is the company becoming more or less liquid? More or less profitable? Were changes in sales and ROA consistent with changes in turnovers of receivables and inventory?) Whenever possible, analysts also compare a company’s ratios with those of similar companies and with those for the industry as a whole. (Are the company’s ratios consistent with, and moving in the same direction as, those for the industry? Are out-of-line ratios or trends explainable?) Several factors make both inter-company and industry comparisons difficult. Comparisons become more difficult as more and more companies diversify their operations. Highly diversified companies might operate in fifteen or more different industries. A welcome trend in financial reporting is increased disclosure of data about the major segments of diversified companies. Such additional disclosure allows analysts to make comparisons that were not possible when only overall results were available. Even comparisons with fairly similar companies must be made with care, because ratios can differ considerably when companies use different accounting methods. For example, differences in the accounting methods used to value inventory (e.g., FIFO and LIFO) can influence many ratios. If purchase prices have generally been rising, a company using LIFO will show a lower inventory, current ratio, ROS, and EPS, and a higher inventory turnover than a company using FIFO. The longer the price trend has continued and the longer the company has used LIFO, the more marked the effects of the difference in inventory method. Consider too the effects of different depreciation methods on ratios. A business using the sum-of-the-years’-digits method will show lower book values for its plant assets than one using the straight-line method; the differences will affect all ratios involving total assets, net income, or both. Even comparisons among similar companies using similar accounting methods can be misleading in the sense that one business could show up better than another in several measures of liquidity, profitability, or solvency and still not be better managed, more successful, or stronger than the other. For example, a company might be too liquid. Too much cash is not as bad as too little cash, but hav-

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ing excessive cash is unwise, because cash does not earn profits unless it is used for something. Faster turnover of inventory could be the result of unnecessarily low selling prices. A shorter collection period on receivables could result from highly restrictive credit policies. Hence, turnovers must be studied in relation to ROS and gross profit ratios, and to trends in the industry. In short, no single ratio, or group of ratios, should be considered in a vacuum. Another factor to consider in evaluating a company is the extent to which one or more ratios can be affected by a single transaction. For example, consider the effects of a large cash payment for a current liability. Such a payment reduces both cash and current liabilities, and has no effect on total working capital. Yet it can improve the current ratio. To illustrate, look at the ratios for Burke Company for 20X2 and assume that it paid current liabilities of $30,000 just before the end of that year. Its current assets before the payment would have been $480,000 ($450,000 + $30,000), and its current liabilities would have been $180,000 ($150,000 + $30,000), giving a current ratio of 2.67 to 1. This ratio is lower than the 3 to 1 we calculated earlier. Before the payment the acid-test ratio would have been 1.6 to 1 [($80,000 + $180,000 + $30,000)/($150,000 + $30,000)]. This is also lower than the ratio calculated earlier (1.73 to 1). Taking actions to improve ratios is called window dressing. This type of window dressing is possible if the current ratio and acid-test ratio are greater than 1 to 1. If those ratios are less than 1 to 1, paying a current liability will reduce them, but window dressing is then possible by delaying payments of current liabilities. Any evaluation based on ratios and comparisons of them must recognize the relative importance of the ratio to the particular industry. The nature of the product and of the production process, the degree of competition in the industry, and many other industry-related factors are relevant in interpreting a particular company’s liquidity, profitability, and solvency ratios. For example, consider the utility industry. Because a utility is a monopoly, the government unit granting the monopoly right also regulates many of the utility’s actions. In most cases, the regulating authority both ensures and limits the utility’s profitability. Utilities seldom have liquidity problems, because their cash flows are relatively stable, because selling a service means they need not maintain inventories, and because their ability to shut off the service minimizes problems in collecting their receivables. For the same reasons, the investing public tolerates more leverage and a lower, but more stable, level of profitability in a utility. All of the preceding considerations point out the need for understanding (1) the company being analyzed and (2) the industry in which the company operates. That a company’s ratios differ from those in the past, or are in-line or out-of-line with those of other companies in the industry, is not good or bad in itself. (In the 1980s, Chrysler Corporation improved its liquidity, profitability, and prospects for solvency, in relation to both its prior performance and to the average for the industry. Nevertheless, the entire industry performed poorly during that period.) Finally, financial statements do not tell analysts all they want to know.

SUMMARY

Ratio analysis is used in making investment decisions. Analysts are concerned with trends in ratios and with whether a company’s ratios are in line with those

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of other companies in the same industry. Ratios can be classified into three major types: liquidity, profitability, and solvency. Which ratios to use and which to emphasize depend on the type of decision to be made. Short-term creditors look primarily at liquidity. Long-term creditors are concerned more with solvency than with liquidity and profitability, but the latter aspects are still important. Current and potential holders of common stock are most interested in profitability, but liquidity and solvency are still significant. Ratio analysis must be used with care. Ratios provide information only in the context of a comparison. Comparisons must be made with other companies and with norms for the industry. Different accounting methods, such as LIFO and FIFO, sum-of-the-years’-digits depreciation and straight-line depreciation, can cause similar companies to show quite different ratios.

KEY TERMS cash flow to total debt (811) common-size statements (796) composition problem (799) convertible securities (806) dilution (of earnings per share) (806) leverage (trading on the equity) (804)

liquidity (798) quick assets (799) solvency (809) window dressing (813) working capital (798)

KEY FORMULAS Liquidity Ratios Accounts receivable turnover

=

sales accounts receivable

Current ratio

=

current assets current liabilities

Days’ sales in accounts receivable =

ending accounts receivable average daily sales

Days’ sales in inventory

=

ending inventory average daily cost of goods sold

Inventory turnover

=

cost of goods sold inventory

Quick ratio =

cash + marketable securities + accounts receivable current liabilities

Profitability Ratios Dividend yield

=

Earnings per share (EPS) =

dividend per share market price per share net income – dividends on preferred stock weighted average common shares outstanding

EVA = After-tax operating profit – (cost of capital × investment)

Chapter Eighteen

Gross profit ratio

=

gross profit sales

Payout ratio

=

dividend per share earnings per share

Analyzing Financial Statements

Price-earnings ratio (PE) =

market price per share earnings per share

Return on assets (ROA)

=

net income + interest + income taxes total assets

Return on common equity (ROE)

=

net income – dividends on preferred stock common stockholders’ equity

Return on sales (ROS)

=

net income sales

815

Solvency Ratios Debt ratio

=

total liabilities total assets

Times interest earnings =

income before interest and taxes interest expense

Cash flow to total debt =

net income + depreciation + amortization + depletion total liabilities + preferred stock

REVIEW PROBLEM Financial statements for Q-Comm Company follow. Q-Comm Company, Balance Sheets at December 31 20X3

20X2

Assets Cash Accounts receivable, net Inventory

$

180,000 850,000 620,000

$

200,000 830,000 560,000

Total current assets Plant and equipment Accumulated depreciation

$ 1,650,000 7,540,000 (1,920,000)

$ 1,590,000 6,650,000 (1,500,000)

Total assets

$ 7,270,000

$ 6,740,000

Accounts payable Accrued expenses

$

220,000 450,000

$

190,000 440,000

Total current liabilities Long-term debt

$

670,000 1,000,000

$

630,000 950,000

Total liabilities Common stock, no par value Retained earnings

$ 1,670,000 4,000,000 1,600,000

$ 1,580,000 4,000,000 1,160,000

Total equities

$ 7,270,000

$ 6,740,000

Equities

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Q-Comm Company, Income Statement for 20X3 Sales Cost of goods sold

$8,650,000 4,825,000

Gross profit Operating expenses: Depreciation Other

$3,825,000 $ 420,000 2,135,000

Total

2,555,000

Income before interest and taxes Interest expense

$1,270,000 70,000

Income before taxes Income taxes at 30%

$1,200,000 360,000

Net income

$ 840,000 Q-Comm Company, Cash Flow Statement for 20X3

Net cash flow from operating activities: Collections from customers Payments to suppliers Payments for operating expenses Interest paid Taxes paid Net cash provided by operations Cash flows for investing activities—purchase of plant and equipment Cash flows for financing activities: Payment of dividends Proceeds from new long-term debt issue

$ 8,630,000 (4,855,000) (2,163,000) (72,000) (320,000) $ 1,220,000 (890,000) $(400,000) 50,000

Net cash for financing activities

(350,000)

Change in cash (decrease) Cash balance, beginning of year

$

(20,000) 200,000

Cash balance, end of year

$

180,000

Q-Comm had 200,000 shares of common stock outstanding throughout the year. The market price of the stock at year end was $65 per share. All sales are on credit.

Required Compute the following ratios as of the end of 20X3 or for the year ended December 31, 20X3, whichever is appropriate. 1. Current ratio. 2. Quick ratio. 3. Accounts receivable turnover. 4. Days’ sales in accounts receivable. 5. Inventory turnover. 6. Days’ sales in inventory. 7. Gross profit ratio. 8. Return on sales (ROS). 9. Return on assets (ROA). 10. Return on equity (ROE).

Chapter Eighteen

Analyzing Financial Statements

11. Earnings per share (EPS). 12. Price-earnings ratio (PE). 13. Dividend yield. 14. Payout ratio. 15. EVA, assuming cost of capital is 12%. 16. Debt ratio. 17. Times interest earned. 18. Cash flow to total debt. ANSWER TO REVIEW PROBLEM 1. Current ratio

$1,650,000 = 2.46 to 1 $670,000 2. Quick ratio

$180,000 + $850,000 = 1.54 to 1 $670,000 3. Accounts receivable turnover

$8,650,000 = 10.3 times ($850,000 + $830,000)/2 4. Days’ sales in accounts receivable

$850,000 = 36 days $8,650,000/365 5. Inventory turnover

$4,825,000 = 8.2 times ($620,000 + $560,000)/2 6. Days’ sales in inventory

$620,000 = 47 days $4,825,000/365 7. Gross profit ratio

$3,825,000 = 44.2% $8,650,000 8. ROS

$840,000 = 9.7% $8,650,000 9. ROA

$840,000 + $70,000 + $360,000 = 18.1% ($7,270,000 + $6,740,000)/2 10. ROE

$840,000 = 15.6% ($5,600,000 + $5,160,000)/2 11. EPS

$840,000 = $4.20 200,000

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12. PE ratio

$65.00 = 15.5 times $4.20 13. Dividend yield

$2 = 3.1% $65 14. Payout ratio

$2.00 = 47.6% $4.20 15. EVA

$1,270,000 × (1 – 30%) – [12% × ($7,270,000 – $670,000)] = $97,000 16. Debt ratio

$1,670,000 = 23.0% $7,270,000 17. Times interest earned

$1,270,000 = 18 times $70,000 18. Cash flow to total debt

$840,000 + $420,000 = 75.4% $1,670,000

ASSIGNMENT MATERIAL INTERNET ACTIVITY The Association for Investment Management and Research (AIMR) sponsors a certification for financial analysts known as Chartered Financial Analyst (CFA). Use a Web search engine such as Yahoo to find the AIMR Web site. Search this site to find out about the CFA examination. Be prepared to describe and discuss what you discovered.

QUESTIONS FOR DISCUSSION 18-1 Dividend yield Your friend bought stock in Acme Corporation five years ago for $25 per share. Acme is now paying a $5 dividend per share and the stock sells for $165. He says that the 20% dividend yield is an excellent return. How did he calculate the dividend yield? Is he correct? 18-2 Ratios and accounting methods LIFO Company uses the last-in first-out method of inventory determination; FIFO Company uses first-in first-out. They have virtually identical operations, physical quantities of inventory, sales, and fixed assets. What differences would you expect to find in the ratios of the companies?

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18-3 Ratios and operating decisions Bronson Company and Corman Company are in the same industry and have virtually identical operations. The only difference between them is that Bronson rents 60% of its plant and equipment on short-term leases, while Corman owns all of its fixed assets. Corman has long-term debt of 60% of the book value of its fixed assets, Bronson has none. The two companies show the same net income because Bronson’s rent and depreciation are the same as Corman’s depreciation and interest. What differences would you expect to find in the ratios of the two companies? 18-4 Foreign exchange risk Coca-Cola gains about 82% of its operating profit outside the United States. It makes most of the product it sells overseas in the host countries. If the dollar strengthens against foreign currencies (a dollar buys more units of foreign currency), will that help or hurt the company? Why? 18-5 Liquidity You are the chief loan officer of a medium-size bank. Two companies have applied for short-term loans, but you can grant only one because of limited funds. Both companies have the same working capital and the same current ratio. They are in the same industry and their current ratios are well above the industry average. What additional information about their current positions would you seek? 18-6 Seasonality and ratios 1. At December 31, 1997, Hasbro, Inc., the toy company, had $783 million accounts receivable. Sales for 1997 were $3,189 million. What are days’ sales in accounts receivable? Why might Hasbro’s days’ sales in receivables seem high at December 31? 2. Hasbro’s inventories at December 31, 1997 were $243 million and its cost of sales for 1997 was $1,359 million. What was its inventory turnover? Do you think the figure reflects what Hasbro experiences throughout the year? 18-7 Price-earnings ratio Your friend says that his investment strategy is simple. He buys stocks with very low PE ratios. He reasons that he is getting the most for his money that way. Do you agree that this is a good strategy? 18-8 Relevance of ratios to industry The 1997 annual report of Bangor HydroElectric Company, a regional electric utility, contained the usual set of financial statements. A condensed balance sheet follows, in thousands of dollars. December 31 1997 1996 Assets Utility plant Current assets Deferred debits and other assets Total assets

$288,754 33,443 278,386

$279,801 37,060 239,768

$600,583

$556,629

$106,558 13,871 221,643 105,213 153,298

$108,321 15,404 274,221 68,155 90,528

$600,583

$556,629

Capitalization and Liabilities Stockholders’ equity Preferred stock Long-term debt Current liabilities Deferred credits Total capitalization and liabilities

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Required Discuss the relevance of the three ratio groups to the analysis of a company such as Bangor Hydro-Electric. 18-9 Ratio variation The Financial Highlights section of an annual report of Motorola Inc. included the values of the following ratios. 1. Return on average invested capital (stockholders’ equity) plus long-term and short-term debt, net of marketable securities. 2. Percent of total debt less marketable securities to total debt less marketable securities plus equity. To which of the three general categories of ratios does each of these ratios belong? How would you explain why the components of these ratios differ from those given in the chapter?

EXERCISES 18-10 Effects of transactions Indicate the effects of each of the following transactions on the company’s (a) current ratio and (b) acid-test ratio. There are three possible answers: (+) increase, (–) decrease, and (0) no effect. Before each transaction takes place, both ratios are greater than 1 to 1. Effects on

Transaction Example: Sell merchandise for cash 1. Buy inventory for cash. 2. Pay an account payable. 3. Borrow cash on a short-term loan. 4. Purchase plant assets for cash. 5. Issue long-term bonds payable. 6. Collect an account receivable. 7. Record accrued expenses payable. 8. Sell a plant asset for cash at a profit. 9. Sell a plant asset for cash at a loss. 10. Buy marketable securities, for cash, as a short-term investment.

(a) Current Ratio

(b) Acid-Test Ratio

+ _______ _______ _______ _______ _______ _______ _______ _______ _______

+ _______ _______ _______ _______ _______ _______ _______ _______ _______

_______

_______

18-11 Relationships Answer the questions for each of the following independent situations. 1. The current ratio is 2.5 to 1. Current liabilities are $200,000. What are current assets? 2. ROA is 18%. ROE is 10%. There is no preferred stock. Net income is $4 million and average total assets are $30 million. What is average stockholders’ equity? 3. The current ratio is 2.5 to 1; the acid-test ratio is 0.9 to 1; cash and receivables are $270,000. The only current assets are cash, receivables, and inventory. (a) What are current liabilities? (b) What is inventory? 4. Accounts receivable turnover is 5 times; inventory turnover is 4 times. The company recently bought inventory. (a) On the average, how long will it be before the

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821

new inventory is sold? (b) On the average, how long after the inventory is sold will cash be collected? 5. A company had current assets of $600,000. It then paid a current liability of $90,000. After the payment, the current ratio was 2 to 1. What were current liabilities before the payment was made? 6. Accounts receivable equal 45 days’ credit sales. The coming year should see sales of $900,000 spread evenly over the year. What should accounts receivable be at the end of the year?

18-12 Leverage Balance Company is considering the retirement of $500,000 in 10% bonds. These bonds are the company’s only interest-bearing debt. The retirement plan calls for the company to issue 10,000 shares of common stock at a total price of $500,000 and use the proceeds to buy back the bonds. Stockholders’ equity is now $1,000,000, with 40,000 shares of common stock outstanding (no preferred stock). The company expects to earn $400,000 before interest and taxes in the coming year. The tax rate is 40%. Required 1. Determine net income, EPS, and ROE for the coming year, assuming that the bonds are retired before the beginning of the coming year. 2. Determine net income, EPS, and ROE for the coming year, assuming that the bonds are not retired. 3. Is the proposed retirement wise? Why or why not? 18-13 Return on assets and return on equity Z-Way Corporation had ROS of 5% and sales of $24 million. Interest expense is $0.3 million; total assets are $16 million; the debt ratio is 40%. There is no preferred stock. Ignore taxes. Required 1. Determine income, ROA, and ROE. 2. Suppose the company could increase its ROS to 6% and keep the same level of sales. What would net income, ROA, and ROE be? 3. Suppose that the company reduced its debt ratio to 20% by retiring debt. New common stock was issued to finance the retirement, keeping total assets at $16 million. Net income is $1.35 million because of lower interest expense that now totals $0.15 million. What are ROA and ROE? 18-14 Financing alternatives The founders of Marmex Company are trying to decide how to finance the company. They have three choices: (a) Issue $8,000,000 in common stock. (b) Issue $4,800,000 in common stock and $3,200,000 in 10% bonds. (c) Issue $4,800,000 in common stock and $3,200,000 in 12% preferred stock. Income before interest and taxes is expected to be $2,000,000. The tax rate is 40%.

Required 1. Compute net income, earnings available for common stock, and ROE for each financing choice. 2. Suppose that the tax rate increases to 60%. Redo requirement 1. Can you draw any conclusions about the effects of tax rates on the relative desirability of the three choices? 18-15 Turnovers and ratios for computer companies The following amounts have been collected from the annual reports for selected computer companies for 1996 and 1997.

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Dell Sales Cost of sales Interest expense Taxes Net income Accounts receivable Inventories Total assets

Compaq

Gateway

1997

1996

1997

1996

1997

1996

12,327 9,605 3 424 944

7,759 6,093 7 216 518

24,584 17,833 168 903 1,855

20,009 14,855 106 565 1,318

6,293 5,217 164 94 110

5,035 4,099 102 132 251

1,486 233 4,268

903 251 2,993

2,891 1,570 14,631

3,718 1,267 12,331

511 249 2,039

450 278 1,673

Required 1. Calculate the return on sales and return on assets for each company for both 1996 and 1997. Use year-end balance sheet values. What can you conclude from these ratios? 2. Calculate the accounts receivable turnover and the inventory turnover for each company for both 1996 and 1997. Use year-end balance sheet values. What can you conclude from these ratios? 18-16 Return on assets and equity Randolph Company has total assets of $12,000,000 and a debt ratio of 30%. Interest expense is $360,000, and return on average total assets is 12%. The company has no preferred stock. Ignore taxes. Required 1. Determine income, average stockholders’ equity, and ROE. 2. Suppose that sales have been $10,800,000 annually and are expected to continue at this level. If the company could increase its ROS by one percentage point, what would be its income, ROA, and ROE? 3. Refer to the original data and your answers to requirement 1. Suppose that Randolph retires $1,800,000 in debt and therefore saves interest expense of $180,000 annually. The company would issue additional common stock in the amount of $1,800,000 to finance the retirement. Total assets would remain at $12,000,000. What would be the income, ROA, and ROE? 18-17 Effects of transactions—returns ratios Indicate the effects of each of the following transactions on the company’s (a) ROS, (b) ROA, and (c) EPS. There are three possible answers: (+) increase, (–) decrease, and (0) no effect. Before each transaction takes place, the ratios are as follows: (a) ROS, 10%; (b) ROA, 5%; (c) EPS, $0.25. Effects on

1. Sell a plant asset for cash, at twice the asset’s book value. 2. Declare and issue a stock dividend. 3. Purchase inventory on account. 4. Purchase treasury stock for cash. 5. Acquire land by issuing common stock.

(a) ROS

(b) ROA

(c) EPS

___ ___ ___ ___ ___

___ ___ ___ ___ ___

___ ___ ___ ___ ___

18-18 Ratios The financial statements for Massin Company, a merchandising company, follow (in thousands of dollars). Massin has 1,000,000 common shares

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outstanding. The price of the stock is $8. Massin declared dividends of $0.10 per share. The balance sheet at the end of 20X1 showed approximately the same amounts as that at the end of 20X2. Massin Company, Income Statement for 20X2 Sales Cost of goods sold

$4,700 2,300

Gross profit Operating expenses: Depreciation Other

$2,400 $ 320 1,230

Total

1,550

Income before interest and taxes Interest expense

$ 850 150

Income before taxes Income taxes

$ 700 280

Net income

$ 420

Massin Company, Balance Sheet at December 31, 20X2 Assets

Equities

Cash Accounts receivable Inventory Total current assets Plant and equipment Accumulated depreciation

$

220 440 410 $ 1,070 5,600 (2,100)

Accounts payable Accrued expenses Total current liabilities Long-term debt Common stock Retained earnings

$ 190 180 $ 370 1,960 1,810 430

Total assets

$ 4,570

Total equities

$4,570

Required Calculate the following ratios. 1. Current ratio. 2. Acid-test ratio. 3. Accounts receivable turnover. 4. Inventory turnover. 5. Gross profit ratio. 6. ROS. 7. ROA. 8. ROE. 9. EPS. 10. PE ratio. 11. Dividend yield. 12. Payout ratio. 13. EVA, assuming a 10% cost of capital. 14. Debt ratio. 15. Times interest earned. 16. Cash flow to total debt.

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PROBLEMS

CHAPTER

11

18-19 Analyzing ROE (adapted from a paper by Professor William E. Ferrara) Chapter 11 introduced the idea of separating the components of ROI as follows: ROI =

net income sales × sales investment

Applying this separation to the calculation of return on stockholders’ equity, we could express ROE as

ROE =

net income sales × stockholders’ equity sales

This separation is less enlightening than it might be, however, because net income combines the effects of financing choices (leverage) with the operating results. Letting total assets/stockholders’ equity stand as a measure of financial leverage, we can also express return on stockholders’ equity as follows:

ROE =

net income sales total assets × × sales total assets stockholders’ equity

Sales and total assets cancel out, leaving the ratio net income/stockholders’ equity. The three-factor expression allows the analyst to look at operations (margin × turnover, the first two terms) separately from financing (the last term). The separation is not perfect because interest (financing expense) is included in calculating net income, but the expansion is adequate for many purposes. Thus, the product of the first two terms is a measure of operating efficiency, while the third is a measure of leverage and therefore of financial risk. The following data summarize results for three companies. Company Results (in thousands of dollars) Sales Net income Total assets Stockholders’ equity ROE

A

B

C

$4,500 $450 $4,500 $3,000 15%

$6,000 $400 $4,500 $2,000 20%

$5,000 $480 $4,400 $4,000 12%

Required Calculate ROE for each company using the three-factor expression and comment on the results. You should be able to draw tentative conclusions about the relative operating and financing results of the companies. 18-20 Current asset activity The treasurer of Billingsgate Company has asked for your assistance in analyzing the company’s liquidity. She provides the following data, in millions of dollars.

Total sales Cost of goods sold Accounts receivable at year end Inventory at year end Accounts payable at year end

20X3

20X2

20X1

$481 322 64 51 36

$440 290 48 44 29

$395 245 31 38 28

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825

Required 1. Compute accounts receivable turnover for 20X2 and 20X3. 2. Compute days’ sales in accounts receivable at the end of 20X2 and 20X3. 3. Compute inventory turnover for 20X2 and 20X3. 4. Compute days’ sales in inventory at the end of 20X2 and 20X3. 5. Comment on the trends in the ratios. Do the trends seem to be favorable or unfavorable? 18-21 Constructing financial statements from ratios The following information is available concerning Warnock Company’s expected results in 20X2 (in thousands of dollars). Turnovers are based on year-end values. Required Fill in the blanks. Return on sales Gross profit percentage Inventory turnover Receivables turnover Current ratio Ratio of total debt to total assets

6% 40% 4 times 5 times 3 to 1 40%

Condensed Income Statement Sales Cost of sales Gross profit Operating expenses Net income

$ 900 _____ _____ _____ $_____ Condensed Balance Sheet

Cash Receivables Inventory Plant and equipment Total

$ 30 $______ ______ 670 $______

Current liabilities Long-term debt Stockholders’ equity

$______ ______ ______

Total

$______

18-22 Effects of transactions on ratios Indicate the effects of each of the following transactions on the company’s current ratio, acid-test ratio, and debt ratio. There are three possible answers: increase (+), decrease (–), and no effect (0). Before each transaction takes place, the current ratio is greater than 1 to 1 and the acid-test ratio is less than 1 to 1. Effects on

Example: An account payable is paid. 1. Bought inventory for cash. 2. A sale is made on account; cost of sales is less than selling price. 3. Issued long-term bonds for cash. 4. Sold land for cash at its book value.

Current Ratio

Acid-Test Ratio

Debt Ratio

+ _______

– _______

– _______

_______ _______

_______ _______

_______ _______

_______

_______

_______

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Effects on

5. Marketable securities held as temporary investments are sold at a gain. 6. Issued common stock in exchange for plant assets. 7. Collected an account receivable. Issued long-term debt for plant assets. 9. Declared, but did not pay, a cash dividend. 10. Paid the dividend in item 9. 11. Paid a short-term bank loan. 12. Recorded depreciation expense.

Current Ratio

Acid-Test Ratio

Debt Ratio

_______

_______

_______

_______ _______

_______ _______

_______ _______

_______

_______

_______

_______ _______ _______ _______

_______ _______ _______ _______

_______ _______ _______ _______

18-23 Comparisons of companies Condensed financial statements for Genco Company and Rella Company appear on the bottom of the following page (in thousands of dollars). Both companies are in the same industry and use the same accounting methods. Balance sheet data for both companies were the same at the end of 20X1 as at the end of 20X2. Required On the basis of the data given, answer the following questions. Support your answers with whatever calculations you believe appropriate. 1. Which company seems to be more liquid? 2. Which company seems to be more profitable? Suppose cost of capital is 12% for both companies. 3. Which company seems to be more solvent? 4. Which stock seems to be a better buy?

18-24 Effects of transactions—selected ratios In the following exhibit, several transactions or events are listed in the left-hand column and the names of various ratios and the value of that ratio before the associated transaction are listed in the right-hand column. Indicate the effect of the transaction on the specified ratio. There are three possible answers: (+) increase, (–) decrease, and (0) no effect. Effect on Ratio

Transaction 1. Write off an uncollectible account receivable. 2. Sell merchandise on account, at less than normal price. 3. Borrow cash on a short-term loan. 4. Write off an uncollectible account receivable. 5. Sell treasury stock at a price greater than its cost. 6. Acquire plant asset by issuing long-term note. 7. Record accrued salaries payable.

_____ _____

Current ratio of 3 to 1 42 days’ sales in accounts receivable

_____

Acid-test ratio of 0.9 to 1

_____

Return on sales of 18%

_____

Return on equity of 20%

_____

Debt ratio of 40%

_____

Times interest earned of 3.2

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Analyzing Financial Statements

827

Effect on Ratio

Transaction 8. Record depreciation on plant assets. 9. Return inventory items to supplier for credit. 10. Acquire plant assets by issuing common stock.

_____

Cash flow to debt ratio of 60%

_____

Inventory turnover of 8 times

_____

Debt ratio of 60%

Balance Sheets, End of 20X2 Genco Company

Rella Company

Assets Cash Accounts receivable Inventory Plant and equipment (net)

$ 185 215 340 850

$

90 170 220 810

Total assets

$1,590

$1,290

Accounts payable Other current liabilities Long-term debt Common stock Retained earnings

$ 150 80 300 700 360

$ 140 90 500 300 260

Total equities

$1,590

$1,290

Equities

Income Statements for 20X2 Genco Company

Rella Company

Sales Cost of goods sold

$3,050 1,400

$2,800 1,350

Gross profit

$1,650

$1,450

Operations expenses: Depreciation Other

$ 280 1,040

$ 240 900

Total

$1,320

$1,140

Income before interest and taxes Interest expense

$ 330 30

$ 310 55

Income before taxes Income taxes at 40%

$ 300 120

$ 255 102

Net income

$ 180

$ 153

Earnings per share Dividends per share Market price of common stock

$0.90 $0.40 $12.00

$0.77 $0.20 $11.50

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18-25 Constructing financial statements using ratios The following data are available for Wasserman Pharmaceutical Company as of December 31, 20X2 and for the year ended. Current ratio Days’ sales in accounts receivable Inventory turnover Debt ratio Current liabilities Stockholders’ equity Return on sales Return on common equity Gross profit ratio

2.5 to 1 55 days 4 times 40% $450,000 $1,500,000 10% 20% 40%

Wasserman has no preferred stock, no marketable securities, and no prepaid expenses. Beginning-of-year balance sheet figures are the same as end-of-year figures. The only noncurrent assets are plant and equipment.

Required Prepare a balance sheet as of December 31, 20X2 and an income statement for 20X2 in as much detail as you can with the available information. Round all figures to the nearest $1,000. 18-26 Dilution of EPS Boston Tarrier Company has been very successful in recent years, as shown by the following data. 20X2

20X3

Net income Preferred stock dividends

$6,200,000 800,000

$8,600,000 800,000

Earnings available for common stock

$5,400,000

$7,800,000

The treasurer of the company is concerned because he expects holders of the company’s convertible preferred stock to exchange their shares for common shares early in the coming year. All of the company’s preferred stock is convertible, and the number of common shares issuable on conversion is 400,000. Throughout 20X2 and 20X3 the company had 600,000 shares of common stock outstanding.

Required 1. Compute basic EPS for 20X2 and 20X3. 2. Compute diluted EPS for 20X2 and 20X3. 18-27 Inventory turnover and return on equity Timmons Company is presently earning net income of $400,000 per year, which gives a 10% ROE. The president believes that inventory can be reduced with tighter controls on buying. Any reduction of inventory frees cash, which would be used to pay a dividend to stockholders. Thus, stockholders’ equity would drop by the same amount as inventory. Inventory turnover is 3 times per year. Cost of goods sold is running at $3,600,000 annually. The president believes that careful management can increase turnover to 5 times. He also believes that sales, cost of goods sold, and net income will remain at their current levels. Required 1. Determine Timmons’s average inventory.

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829

2. Determine Timmons’s average inventory if turnover could be increased to 5 times per year. 3. Determine ROE if Timmons can increase turnover and reduce stockholders’ equity by the amount of the reduction in investment in inventory.

18-28 Ratios—industry averages The president of Brewster Company has been concerned about its operating performance and financial strength. She has obtained, from a trade association, the averages of certain ratios for the industry. She gives you these ratios and the company’s most recent financial statements (in thousands of dollars). The balance sheet amounts were about the same at the beginning of the year as they are now. Brewster Company, Balance Sheet as of December 31, 20X1 Assets

Equities

Cash Accounts receivable Inventory Total current assets Plant and equipment, net

$

860 3,210 2,840 $ 6,910 7,090

Accounts payable Accrued expenses Taxes payable Total current liabilities Bonds payable, due 19X9 Common stock, no par Retained earnings

$

975 120 468 $ 1,563 6,300 4,287 1,850

Total assets

$14,000

Total equities

$14,000

Brewster Company, Income Statement for 20X1 Sales Cost of goods sold

$11,800 7,350

Gross profit Operating expenses, including $650 depreciation

$ 4,450 2,110

Operating profit Interest expense

$ 2,340 485

Income before taxes Income taxes at 40%

$ 1,855 742

Net income

$ 1,113

Brewster has 95,000 shares of common stock outstanding, which gives earnings per share of $11.72 ($1,113,000/95,000). Dividends are $5 per share and the market price of the stock is $120. Average ratios for the industry are as follows: Current ratio Quick ratio Accounts receivable turnover Inventory turnover Return on sales Return on assets Cash flow to total debt

3.8 to 1 1.9 to 1 4.8 times 3.6 times 7.6% 17.6% 25.0%

Return on equity Price-earnings ratio Dividend yield Payout ratio Debt ratio Times interest earned

Required 1. Compute the ratios shown above for Brewster Company.

17.5% 12.3 3.9% 38.0% 50.0% 6 times

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2. Prepare comments to the president indicating areas of apparent strength and weakness for Brewster Company in relation to the industry.

18-29 Generating cash flows Humbert Company must make a $900,000 payment on a bank loan at the end of March 20X2. At December 31, 20X1, Humbert had cash of $125,000 and accounts receivable of $632,000. Estimated cash payments required during the first three months of 20X2, exclusive of the payment to the bank, are $645,000. Humbert expects sales to be $1,200,000 in the three-month period, all on credit. Accounts receivable normally equal about 45 days’ sales. Required 1. Determine the expected balance in accounts receivable at the end of March 20X2. 2. Determine whether the company will have enough cash to pay the bank loan on March 31, 20X2.

CASES 18-30 Evaluation of trends and comparison with industry Comparative balance sheets and income statements for Marcus Manufacturing Company appear on the following page (in thousands of dollars). Your boss, the chief financial analyst for Hanmattan Bank, has asked you to analyze trends in the company’s operations and financing and to make some comparisons with the averages for the same industry. The bank is considering the purchase of some shares of Marcus for one of its trust funds. Selected data from the 20X2 balance sheet (in thousands of dollars) include the following: Accounts receivable Inventory (all finished goods) Total assets Stockholders’ equity

$ 510 620 2,940 1,320

The following are averages for Marcus’s industry. Current ratio Quick ratio Debt ratio Price-earnings ratio Dividend yield Payout ratio

2.7 to 1 1.4 to 1 52% 11.5 4.5% 48.0%

Receivables turnover Inventory turnover Return on assets Return on equity Return on sales

8.5 times 4.2 times 15.0% 13.5% 5.0%

Required Compute the above ratios for Marcus for 20X3 and 20X4 and comment on the trends in the ratios and on relationships to industry averages. 18-31 Trends in ratios As the chief investment officer of a large pension fund, you must make many investing decisions. One of your assistants has prepared the following ratios for MBI Corporation, a large multinational manufacturer.

Chapter Eighteen

831

Analyzing Financial Statements

Marcus Manufacturing Company, Balance Sheets as of December 31 20X4

20X3

Cash Accounts receivable Inventory (all finished goods)

$ 170 850 900

$ 180 580 760

Total current assets Plant and equipment, net

$1,920 2,050

$1,520 1,800

Total assets

$3,970

$3,320

Current liabilities Long-term debt Common stock Retained earnings

$ 812 1,640 1,000 518

$ 620 1,300 1,000 400

Total equities

$3,970

$3,320

Assets

Equities

Marcus Manufacturing Company, Income Statements 20X4

20X3

Sales Cost of goods sold

$4,700 2,670

$4,350 2,460

Gross profit Operating expenses

$2,030 1,470

$1,890 1,440

Income before interest and taxes Interest expense

$ 560 130

$ 450 100

Income before taxes Income taxes at 40%

$ 430 172

$ 350 140

Net income

$ 258

$ 210

Earnings per share Market price of stock at year end Dividends per share

$2.58 $32.00 $0.96

$2.10 $28.00 $0.80

Current ratio Quick ratio Receivable turnover Inventory turnover Debt ratio Return on assets Return on equity Price-earnings ratio Times interest earned Earnings per share growth rate

Industry Average All Years

20X3

20X2

20X1

2.4 1.6 8.1 4.0 43.0% 17.8% 15.3% 14.3 8.3 8.4%

2.6 1.55 7.5 4.3 38.0% 19.1% 15.1% 13.5 9.7 7.1%

2.4 1.6 7.9 4.2 41.3% 19.4% 15.6% 13.3 9.5 6.9%

2.5 1.65 8.3 4.0 44.6% 19.5% 15.9% 13.4 8.9 7.0%

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Required What is your decision in the following cases? Give your reasons. 1. Granting a short-term loan to MBI. 2. Buying long-term bonds of MBI on the open market. The bonds yield 7%, which is slightly less than the average for bonds in the industry. 3. Buying MBI common stock.

18-32 Financial planning with ratios The treasurer of SmartStore, Inc., a large chain of convenience stores, has been trying to develop a financial plan. In conjunction with other managers, she has developed the following estimates, in millions of dollars.

Sales Plant assets, net

20X1

20X2

20X3

20X4

$100 80

$120 95

$150 110

$210 125

In addition, for planning purposes she is willing to make the following estimates and assumptions about other results. Cost of goods sold as a percentage of sales Return on sales Dividend payout ratio Turnovers based on year-end values: Cash and accounts receivable Inventory Required current ratio Required ratio of long-term debt to stockholders’ equity

55% 15% 20% 5 times 4 times 3 to 1 50%

At the beginning of 20X1 the treasurer expects stockholders’ equity to be $60 million and long-term debt to be $30 million.

Required Prepare pro forma balance sheets and any supporting schedules you need for the end of each of the next four years. Determine how much additional common stock, if any, the company will have to issue each year if the treasurer’s estimates and assumptions are correct. 18-33 Leverage Mr. Harmon, treasurer of Stokes Company, has been considering two plans for raising $2,000,000 for plant expansion and modernization. One choice is to issue 9% bonds. The other is to issue 25,000 shares of common stock at $80 per share. The modernization and expansion is expected to increase operating profit, before interest and taxes, by $320,000 annually. Depreciation of $200,000 is included in the $320,000. Condensed financial statements for 20X2 follow (in thousands of dollars). Stokes Company, Balance Sheet as of December 31, 20X2 Assets

Equities

Current assets Plant and equipment, net Other assets

$ 3,200 7,420 870

Current liabilities Long-term debt, 7% Stockholders’ equity

$ 1,200 3,000 7,290

Total assets

$11,490

Total equities

$11,490

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Analyzing Financial Statements

833

Stokes Company, Income Statement for 20X2 Sales Cost of sales Operating expenses Total

$8,310 $5,800 1,200 7,000

Operating profit Interest expense

$1,310 210

Income before taxes Income taxes at 40%

$1,100 440

Net income

$ 660

Earnings per share* Dividends per share

$6.60 $3.30

* Based on 100,000 outstanding shares

Mr. Harmon is concerned about the effects of issuing debt. The average debt ratio for companies in the industry is 42%. He believes that if this ratio is exceeded, the PE ratio of the stock will fall to 11 because of the potentially greater risk. If Stokes increases its common equity substantially by issuing new shares, he expects the PE ratio to increase to 12.5. He also wonders what will happen to the dividend yield under each plan. The company follows the practice of paying dividends equal to 50% of net income.

Required 1. For each financing plan, calculate the debt ratio that the company would have after the securities (bonds or stocks) are issued. 2. For each financing plan, determine the expected net income in 20X3, expected EPS, and the expected market price of the common stock. 3. Calculate, for each financing plan, the dividend per share that Stokes would pay following its usual practice and the yield that would be obtained at the market prices from your answer to requirement 2. 4. Suppose that you now own 100 shares of Stokes Company. Which alternative would you prefer the company to use? Why?