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Chapter 8

Analysis of Financial StatementsANSWERS TO BEGINNING-OF-CA!TER "#ESTIONS

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The answers to these questions are all contained in the BOC Excel model for this chapter, wherethey are illustrated with actual data and the ratios are calculated.

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Answers and Solutions: 8 - (

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ANSWERS TO EN)-OF-CA!TER "#ESTIONS

8-1 a. liquidity ratio is a ratio that shows the relationship of a firm!s cash and othercurrent assets to its current lia"ilities. The current ratio is found "y di#idin$ currentassets "y current lia"ilities. %t indicates the extent to which current lia"ilities areco#ered "y those assets expected to "e con#erted to cash in the near future. Thequic&, or acid test, ratio is found "y ta&in$ current assets less in#entories and thendi#idin$ "y current lia"ilities.

". sset mana$ement ratios are a set of ratios that measure how effecti#ely a firm ismana$in$ its assets. The in#entory turno#er ratio is sales di#ided "y in#entories.

'ays sales outstandin$ is used to appraise accounts recei#a"le and indicates thelen$th of time the firm must wait after ma&in$ a sale "efore recei#in$ cash. %t isfound "y di#idin$ recei#a"les "y a#era$e sales per day. The fixed assets turno#erratio measures how effecti#ely the firm uses its plant and equipment. %t is the ratio ofsales to net fixed assets. Total assets turno#er ratio measures the turno#er of all thefirm!s assets( it is calculated "y di#idin$ sales "y total assets.

c. )inancial le#era$e ratios measure the use of de"t financin$. The de"t ratio is the ratioof total de"t to total assets, it measures the percenta$e of funds pro#ided "y creditors.The times-interest-earned ratio is determined "y di#idin$ earnin$s "efore interest andtaxes "y the interest char$es. This ratio measures the extent to which operatin$

income can decline "efore the firm is una"le to meet its annual interest costs. TheEB%T' co#era$e ratio is similar to the times-interest-earned ratio, "ut it reco$ni*esthat many firms lease assets and also must ma&e sin&in$ fund payments. %t is found"y addin$ EB%T' and lease payments then di#idin$ this total "y interest char$es,lease payments, and sin&in$ fund payments o#er one minus the tax rate.

d. +rofita"ility ratios are a $roup of ratios, which show the com"ined effects of liquidity,asset mana$ement, and de"t on operations. The profit mar$in on sales, calculated "ydi#idin$ net income "y sales, $i#es the profit per dollar of sales. Basic earnin$ poweris calculated "y di#idin$ EB%T "y total assets. This ratio shows the raw earnin$power of the firm!s assets, "efore the influence of taxes and le#era$e. eturn on total

assets is the ratio of net income to total assets. eturn on common equity is found "ydi#idin$ net income into common equity.

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e. ar&et #alue ratios relate the firm!s stoc& price to its earnin$s and "oo& #alue pershare. The priceearnin$s ratio is calculated "y di#idin$ price per share "y earnin$sper share--this shows how much in#estors are willin$ to pay per dollar of reportedprofits. The pricecash flow is calculated "y di#idin$ price per share "y cash flow per

share. This shows how much in#estors are willin$ to pay per dollar of cash flow.ar&et-to-"oo& ratio is simply the mar&et price per share di#ided "y the "oo& #alueper share. Boo& #alue per share is common equity di#ided "y the num"er of sharesoutstandin$.

f. Trend analysis is an analysis of a firm!s financial ratios o#er time. %t is used toestimate the li&elihood of impro#ement or deterioration in its financial situation.Comparati#e ratio analysis is when a firm compares its ratios to other leadin$companies in the same industry. This technique is also &nown as "enchmar&in$.

$. The 'u +ont equation is a formula, which shows that the rate of return on assets can

"e found as the product of the profit mar$in times the total assets turno#er. /indowdressin$ is a technique employed "y firms to ma&e their financial statements loo&"etter than they really are. 0easonal factors can distort ratio analysis. t certaintimes of the year a firm may ha#e excessi#e in#entories in preparation of a season2of hi$h demand. Therefore an in#entory turno#er ratio ta&en at this time as opposedto after the season will "e radically distorted.

8-3 The emphasis of the #arious types of analysts is "y no means uniform nor should it "e.Managementis interested in all types of ratios for two reasons. )irst, the ratios point outwea&nesses that should "e stren$thened( second, mana$ement reco$ni*es that the otherparties are interested in all the ratios and that financial appearances must "e &ept up if thefirm is to "e re$arded hi$hly "y creditors and equity in#estors. Equity investors areinterested primarily in profita"ility, "ut they examine the other ratios to $et informationon the ris&iness of equity commitments. Long-term creditorsare more interested in thede"t ratio, T%E, and fixed-char$e co#era$e ratios, as well as the profita"ility ratios.Short-term creditorsemphasi*e liquidity and loo& most carefully at the liquidity ratios.

8-4 5i#en that sales ha#e not chan$ed, a decrease in the total assets turno#er means that thecompany!s assets ha#e increased. lso, the fact that the fixed assets turno#er ratioremained constant implies that the company increased its current assets. 0ince thecompany!s current ratio increased, and yet, its quic& ratio is unchan$ed means that thecompany has increased its in#entories.

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8-6 'ifferences in the amounts of assets necessary to $enerate a dollar of sales cause assetturno#er ratios to #ary amon$ industries. )or example, a steel company needs a $reaternum"er of dollars in assets to produce a dollar in sales than does a $rocery store chain.lso, profit mar$ins and turno#er ratios may #ary due to differences in the amount ofexpenses incurred to produce sales. )or example, one would expect a $rocery store chain

to spend more per dollar of sales than does a steel company. Often, a lar$e turno#er will"e associated with a low profit mar$in, and #ice #ersa.

8-7 a. Cash, recei#a"les, and in#entories, as well as current lia"ilities, #ary o#er the year forfirms with seasonal sales patterns. Therefore, those ratios that examine "alance sheetfi$ures will #ary unless a#era$es monthly ones are "est9 are used.

". Common equity is determined at a point in time, say 'ecem"er 41, 3::;. +rofits areearned o#er time, say durin$ 3::;. %f a firm is $rowin$ rapidly, year-end equity will"e much lar$er than "e$innin$-of-year equity, so the calculated rate of return onequity will "e different dependin$ on whether end-of-year, "e$innin$-of-year, or

a#era$e common equity is used as the denominator. #era$e common equity isconceptually the "est fi$ure to use. %n pu"lic utility rate cases, people are reported toha#e deli"erately used end-of-year or "e$innin$-of-year equity to ma&e returns onequity appear excessi#e or inadequate. 0imilar pro"lems can arise when a firm is"ein$ e#aluated.

8-; )irms within the same industry may employ different accountin$ techniques, which ma&eit difficult to compare financial ratios. ore fundamentally, comparisons may "emisleadin$ if firms in the same industry differ in their other in#estments. )or example,comparin$ +epsico and Coca-Cola may "e misleadin$ "ecause apart from their soft drin&"usiness, +epsi also owns other "usinesses such as )rito-)C.

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SO,#TIONS TO EN)-OF-CA!TER !ROB,ES

8-1 C ? @4,:::,:::(C ratios 5ase7 on the pro;ecte7 5alance sheet

an7 income statement 7ata3 What can yo say a5ot the company of ratios as

5ein4 sefl $ to mana4ers to help rn the 5siness6 % to 5an>ers for cre7it

analysis6 an7 & to stoc>hol7ers for stoc> :alation3 Wol7 these 7ifferent typesof analysts ha:e an eDal interest in the liDi7ity ratios

Ans2er0 Current atio:H ? Current ssetsCurrent

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industry, in which case, its fixed assets are older and thus ha#e "een depreciatedmore, or that Computron!s cost of fixed assets were lower than most firms in theindustry.9

73 Calclate the %//+ 7e5t6 times-interest-earne76 an7 EBIT)A co:era4e ratios3

o2 7oes Comptron compare 2ith the in7stry 2ith respect to financial

le:era4e What can yo concl7e from these ratios

Ans2er0 'e"t atio:H? Total

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O:H? et %ncomeTotal ssets ? @374,786@4,71;,J73 ? H.3.

OE:H? et %ncomeCommon Equity ? @374,786@1,JHH,173 ? 13.8.

The firm!s profit mar$in is a"o#e 3::7 and 3::; le#els and is at the industrya#era$e. The "asic earnin$ power, O, and OE ratios are a"o#e "oth 3::7 and3::; le#els, "ut "elow the industry a#era$e due to poor asset utili*ation.

f3 Calclate the %//+ price1earnin4s ratio6 price1cash flo2 ratios6 an7 mar>et15oo>

ratio3 )o these ratios in7icate that in:estors are e9pecte7 to ha:e a hi4h or lo2

opinion of the company

Ans2er0 E+0 ? et %ncome0hares Outstandin$ ? @374,78637:,::: ? @1.:164.

+riceEarnin$s:H ? +rice +er 0hareEarnin$s +er 0hare

? @13.1H@1.:164 ? 13.:

.

Chec&D +rice ? E+0 +E ? @1.:164139 ? @13.1H.

Cash )low0hare:H ? % F 'E+90hares? @374,786 F @13:,:::937:,:::? @1.6J.

+riceCash )low ? @13.1H@1.6J ? 8.3.

BL+0 ? Common Equity0hares Outstandin$? @1,JHH,17337:,::: ? @H.J1.

ar&etBoo& ? ar&et +rice +er 0hareBoo& Lalue +er 0hare? @13.1H@H.J1 ? 1.76x.

Both the +E ratio and BL+0 are a"o#e the 3::7 and 3::; le#els "ut "elow theindustry a#era$e.

43 !erform a common sie analysis an7 percent chan4e analysis3 What 7o these

analyses tell yo a5ot Comptron

Ans2er0 )or the common si*e "alance sheets, di#ide all items in a year "y the total assets forthat year. )or the common si*e income statements, di#ide all items in a year "y thesales in that year.

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Common Sie Balance Sheets

Assets

3::7 3::; 3::He %nd.Cash :.; :.4 :.6 :.40hort Term %n#estments 4.4 :.H 3.: :.4ccounts ecei#a"le 34.J 31.J 37.: 33.6%n#entories 68.H 66.; 68.8 61.3 Total Current ssets H;.7 ;H.6 H;.3 ;6.15ross )ixed ssets 44.6 61.H 46.H 74.J

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Computron has hi$her proportion of in#entory and current assets thanindustry. Computron has sli$htly more equity which means less de"t9 than industry.Computron has more short-term de"t than industry, "ut less lon$-term de"t thanindustry. Computron has lower CO50 than industry, "ut hi$her other expenses.

esult is that Computron has similar EB%T as industry.

)or the percent chan$e analysis, di#ide all items in a row "y the #alue in the firstyear of the analysis.

!ercent Chan4e Balance Sheets

Assets3::7 3::; 3::He

Cash :.: -1J.1 77.;0hort Term %n#estments :.: -78.8 6H.6ccounts ecei#a"le :.: 8:.: 17:.:

%n#entories :.: 8:.: 16:.:

Total Current ssets :.: H4.3 148.6

5ross )ixed ssets :.: 167.:

168.7

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!ercent Chan4e Income Statement 3::7 3::; 3::He0ales :.: H:.: 1:7.:

Cost Of 5oods 0old :.: H4.J 1:3.7Other Expenses :.: 111.8 8:.4'epreciation :.: 718.8 746.J

Total Operatin$ Costs :.: 8:.7 1:3.H

EB%T :.: -J1.H 16:.6

%nterest Expense :.: 181.; 38.: EBT :.: -

3:8.3188.4

Taxes 6:9 :.: -

3:8.3188.4

et %ncome :.: -

3:8.3188.4

/e see that 3::H sales $rew 1:7 from 3::7, and that % $rew 188 from 3::7.0o Computron has "ecome more profita"le. /e see that total assets $rew at a rate of14J, while sales $rew at a rate of only 1:7. 0o asset utili*ation remains apro"lem.

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h3 #se the e9ten7e7 ) !ont eDation to pro:i7e a smmary an7 o:er:ie2 of

Comptron

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;3 What are some Dalitati:e factors analysts shol7 consi7er 2hen e:alatin4 a

companyely ftre financial performance

Ans2er0 Top analysts reco$ni*e that certain qualitati#e factors must "e considered when

e#aluatin$ a company. These factors, as summari*ed "y the merican ssociation Of%ndi#idual %n#estors %%9, are as followsD

1. re the company!s re#enues tied to one &ey customerA

3. To what extent are the company!s re#enues tied to one &ey productA

4. To what extent does the company rely on a sin$le supplierA

6. /hat percenta$e of the company!s "usiness is $enerated o#erseasA

7. Competition

;. )uture prospects

H.