Professional Documents
Culture Documents
Analysis
April 1995
Financial Statement Analysis
Warning
This workbook is the product of, and
copyrighted by, Citibank North America, Inc.
It is solely for the internal use of Citibank,
North America, Inc. and may not be used for
any other purpose. It is unlawful to reproduce
the contents of these materials, in whole or in
part, by any method, printed, electronic, or
otherwise; or to disseminate or sell the same
without the prior written consent of the
Training and Development Centers for Latin
America, Asia/Pacific and CEEMEA.
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Table of Contents
TABLE OF CONTENTS
Introduction
Course Overview ......................................................................................... vii
Course Objectives ...................................................................................... viii
The Workbook...............................................................................................ix
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Unit 1: Accounting Issues in Financial Analysis (Continued)
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Unit 2: Basic Concepts of Financial Analysis (Continued)
Funds Generation Statement........................................................2-31
Summary of Sources and Uses ...................................................2-33
Funds Flow Analysis .....................................................................2-33
Summary...................................................................................................2-34
Progress Check 2.2 ..................................................................................2-35
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Unit 4: Financial Ratios — Liquidity
Introduction..................................................................................................4-1
Unit Objectives ............................................................................................4-1
Financial Ratios...........................................................................................4-2
Types of Financial Ratios................................................................4-2
Liquidity Ratios ............................................................................................4-3
Current Ratio...................................................................................4-3
Acid Test .........................................................................................4-6
Other Liquidity Indicators.................................................................4-8
Progress Check 4.1 ....................................................................................4-9
How Liquidity Ratios Change ....................................................................4-17
Progress Check 4.2 ..................................................................................4-21
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Unit 6: Financial Ratios — Turnover
Introduction..................................................................................................6-1
Unit Objectives ............................................................................................6-2
Receivables Turnover / Days Receivable...................................................6-2
Receivables Turnover Ratio............................................................6-2
Days Receivable .............................................................................6-4
Summary.........................................................................................6-6
Progress Check 6.1 ........................................................................6-9
Inventory Turnover or Days Inventory .......................................................6-13
Inventory Turnover.........................................................................6-13
Days Inventory...............................................................................6-14
Summary.......................................................................................6-17
Progress Check 6.2 ..................................................................................6-19
Payables Turnover or Days Payable ........................................................6-23
Payables Turnover ........................................................................6-23
Days Payable ................................................................................6-24
Common Variation ............................................................6-25
Seasonality........................................................................6-26
Interpreting the Number ....................................................6-27
Summary.......................................................................................6-28
Progress Check 6.3 ..................................................................................6-29
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Unit 7: Financial Ratios — Profitability (Continued)
Summary.......................................................................................7-15
Progress Check 7.2 ..................................................................................7-17
Summary of Financial Ratios....................................................................7-21
Appendices
Appendix A...................................................................................................A-1
Appendix B ..................................................................................................B-1
Appendix C — Glossary..............................................................................C-1
Index
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Introduction
INTRODUCTION
COURSE OVERVIEW
Welcome!
You are about to learn the basic financial concepts and techniques used to interpret and
analyze the financial and economic position of a company. These techniques form the
foundation of financial statement analysis. After completing the course, you should be able
to apply financial analysis techniques to perform an in-depth quantitative analysis of a
company’s financial situation.
This course is useful for relationship manager trainees and others working in the credit area
who wish to improve their credit analysis capabilities in order to support individual credit
decisions.
The opening unit of this workbook deals with accounting issues as they pertain to financial
statement analysis. The workbook does not teach accounting. If the reader has very little
exposure to accounting, it may be more productive to first upgrade accounting skills
through an accounting textbook or self-instruction workbook (e.g. Robert N. Anthony’s
Essentials of Accounting). If you do not have the Anthony self-instruction book available,
contact your Training Coordinator or the PDC.
A brief section on financial statement structure is included in Appendix A, along with some
short exercises, to provide support for readers with an incomplete knowledge of
accounting. The material may be helpful to refresh some concepts, but it is insuffient to
teach the subject.
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viii INTRODUCTION
We have designed this course in workbook form which follows a logical sequence
using a self-instructional format. You should work through the units at your own pace in the
order they're presented, because each contains information that builds from previous units.
For your convenience, we have included a glossary of terms at the back of the workbook.
COURSE OBJECTIVES
+ Recognize some basic concepts that help an analyst form a more complete
picture of a company’s financial health
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INTRODUCTION ix
THE WORKBOOK
This workbook is designed to give you complete control over your own learning. The
material is divided into workable sections, each containing everything you need to master
the content. You can move through the workbook at your own pace and go back to review
ideas that you didn’t completely understand the first time. Each unit contains:
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x INTRODUCTION
Since this is a self-instructional course, your progress will not be supervised. We expect
you to complete the course to the best of your ability and at your own speed. Now that you
know what to expect, please begin with Unit One. Good luck!
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Unit 1
UNIT 1: ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
INTRODUCTION
UNIT OBJECTIVES
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1-2 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
BRANCHES OF ACCOUNTING
1. Managerial accounting
2. Tax accounting
3. Financial accounting
Managerial Accounting
Tax Accounting
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-3
Financial Accounting
From this information base, the analyst can build projected numbers,
based on historical trends and prudent economic and business
assumptions, to measure the business risk of dealing with this actual
or potential client. It is this type of accounting that concerns us in
this workbook.
Example While many of the principles are universal, others may vary from
country to country or region to region. The impact of area-specific
principles can be demonstrated with an example. Only one European
firm (Daimler Benz) is now listed on the New York Stock Exchange
because it is the only European company that has been willing to
express its financial statements in accordance with the requirements
of the FASB in the United States. Currently, there may be fundamental
differences in accounting principles applied from country to country,
but the trend internationally is to unify standards over time.
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1-4 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Effects of Inflation
While the level of inflation recently has been reduced in most Latin
countries, many of these countries (Brazil, Chile, Peru, Mexico, etc.)
still maintain a monetary correction scheme that is at variance with
the GAAP of the United States. This scheme may be in place for some
time due to the fact that inflation levels, which are considerably lower
than in the past, are still high by US standards. If lower inflation
becomes a permanent feature, the need for monetary correction will be
eliminated and use of this methodology may be phased out in many of
these Latin countries (as occurred in Argentina in late 1995). As this
occurs in other countries as well, unification of standards with the US
may become possible in the future.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-5
When you have completed the exercise, check your answers with
the answer key in Appendix A. If your level of understanding is
insufficient to complete the exercise with substantially correct
numbers, we recommend upgrading your accounting knowledge,
perhaps through an accounting textbook or self-instruction workbook
(e.g. Robert N. Anthony’s Essentials of Accounting) or refreshing
your skills by working through Appendix B — Financial Statement
Structure.
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1-6 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Accounting Exercise
PART 1: Use the indivi dual accounts below to create a balance sheet and an income statement.
Fill in the blanks on the next two pages and calculate the subtotals
and totals.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-7
BALANCE SHEET
Assets Liabilities
__________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
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___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
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___________________________ __ ___________________________ __
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___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
___________________________ __ ___________________________ __
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1-8 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
INCOME STATEMENT
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
____________________________ ____
Net Income _______
PART 2: What are the short-term bank debt, ending retained earnings, balance sheet totals,
and income statement subtotals?
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-9
Special The objective of a good financial analyst should be to “get behind the
accounting numbers” to achieve greater depth and quality in risk and needs
issues to assessment. There are many special accounting issues and areas that
consider should be considered, including:
n Contextual factors
n Asset / liability valuation
n Intangible assets
n Contingent liabilities
n Adjustments for inflation
Contextual Factors
Macroeconomic Effects
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1-10 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Consolidated Numbers
Combined The analyst’s job may become more complex when analyzing
financial consolidated financial numbers for a group of companies.
statements Consolidated numbers represent the combined financial statements
of a group of interrelated companies that report as if they are one
company.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-11
Seasonality
Seasonal Many companies have to deal with seasonal production or sales. For
business activity some companies, the seasonality of their activity is obvious, as in the
agricultural or agroindustrial sectors; for other companies, the effect
may be less pronounced. For still others, seasonality may not be a
factor.
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1-12 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Application of The applicable GAAP should govern the valuation methodology used
appropriate for preparing the numbers and, theoretically, if the correct principle
GAAP is followed, the numbers should be trustworthy. Sometimes, however,
the principles are not applied evenly and the analyst must assess the
value of the asset or liability as listed on the balance sheet.
While the accounting cost principle states that all items will be
recorded at original cost, the accounting profession also recognizes
the need to reflect an updated value where accumulated inflation may
cause historical cost to be misleading. For example, in most (if not
all) Latin American countries, it would be inappropriate to value fixed
plant and equipment that was acquired in the mid 1970s, with
a useful life of 40 years, at present depreciated cost valuation. This
would be misleading when the analyst considers that accumulated
inflation during these intervening 20 years may exceed 20,000% in
some countries.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-13
Intangible Assets
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1-14 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Example: Having said this, however, we must understand the logic and apply
Licenses it to other intangibles. Consider patents, copyrights, and licensing
agreements. What is a brewery or soft drink bottling company’s most
valuable asset when it produces someone else’s branded product?
What is the most valuable asset for a distiller, a perfume / cosmetics
producer, or a cigarette manufacturer? Answer: The license to
produce the branded product.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-15
Contingent Liabilities
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1-16 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
This is another area where US and Latin American GAAP may differ.
US GAAP require capitalization on the balance sheet of all items
acquired as capital leases, along with the corresponding liabilities,
valued at the net present value of the lease. Operating leases are
charged to expenses. Some countries in Latin America require similar
treatment, but others may not.
The analyst should clearly understand how these rules apply within
his/her jurisdiction. Some questions to ask include: What are the
specific rules? What is a capital lease and what is an operating lease?
Where there are ambiguities or an alternative accounting treatments,
these ambiguities or alternatives should be clearly understood.
SUMMARY
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-17
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1-18 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-19
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 2: A company wants to know how much it will have to pay the local regulatory
agency if it implements a new product that is profitable. This is an example
of:
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1-20 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
b) financial accounting.
Question 2: A company wants to know how much it will have to pay the local regulatory
agency if it implements a new product that is profitable. This is an example
of:
c) tax accounting.
c) managerial accounting.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-21
Question 4: The responsibility of the FASB or its equivalent in other countries is to:
Question 5: Identify three business factors that may affect the interpretation of a
company’s financial statements.
Question 6: When Generally Accepted Accounting Principles are not evenly applied:
____ a) the value of fixed assets must be adjusted to account for inflation.
____ b) the taxes applied to the revaluation of assets must be considered.
____ c) there is no impact on the balance sheet.
____ d) the resulting numbers may not fairly reflect the financial position
of the company.
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1-22 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
Question 4: The responsibility of the FASB or its equivalent in other countries is to:
Question 5: Identify three business factors that may affect the interpretation of a
company’s financial statements.
a) Low inflation
Question 6: When Generally Accepted Accounting Principles are not evenly applied:
d) the resulting numbers may not fairly reflect the financial position
of the company.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-23
Question 7: Intangible “assets” such as brand names developed by a company are difficult
to value because:
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1-24 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
c) their values may not have been tested on the open market.
b) Corporate guarantee
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-25
Accounts stated Although all items are exposed to inflation, the impact can be low
at historical or high depending on the turnover of the item. Inventories is one
value example. If a company has a high turnover of inventories, the cost
reported in the balance sheet will be relatively close to current or
replacement cost. Conversely, if the turnover is low, considering that
historical cost is used to value inventories, the reported cost will be
lower than the current or replacement cost.
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1-26 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Accounts stated In countries where inflation has been high for a long time, a significant
at future value distortion is created in the form of “expected inflation.” This occurs
when the price for a credit sale is significantly higher than the price
for a cash sale. In this situation, the accounts receivable in the
seller's books and the accounts payable in the buyer's books are
reported in future value terms.
Accounts stated When balances in accounts are stated at present value, they are
at present value expressed in terms of their purchasing power as of the date of the
financial statements. The best example of a present-value account
is Cash, which includes all funds immediately available to the
company.
Reflects a Inflation impacts the income statement in a different way. The income
period of growth statement reports the results accumulated over a period of time and,
therefore, even when operating volumes remain constant, income and
expense figures grow from year to year. Earnings per share also
become proportionally higher, unless the company issues additional
shares at inflated prices. In inflationary environments, companies
seem to grow all the time. Judging only from a series of consecutive
income statements, bankers would be very happy to grant credit to
many of them.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-27
Uneven But, this is not the only problem. Since income statements compile
measurements data from several months, the aggregate measurements are made with
resulting from quite different yardsticks. This is not so important when sales and
seasonality expenses are relatively even throughout the year, but seasonal flows
are quite common for many companies. Consequently, revenues of
companies with sales concentrated in the beginning
of the year are understated and revenues of companies with sales
concentrated in the end of the year are overstated. The same applies to
expenses.
Inflationary Accounting
Problems All accountants agree that the effects of inflation must be measured,
but most also agree that existing methods are experimental, involve
too many assumptions and judgments, and results are only estimates.
Also, GAAP and income tax regulations vary from country to country.
In some cases, even inflation indices published by the government
agencies are not reliable.
Foreign For several countries, the US dollar is more stable than local currency
currency and, therefore, many companies keep unofficial accounts in US
accounting dollars. These accounts usually have no legal value, but they can help
the analyst make better judgments, even though inflation also affects
US dollars.
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1-28 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Monetary items The nominal value of monetary items, such as cash, accounts
receivable, accounts payable, and bank debt, remains constant over
time. Obviously, in an inflationary environment, the associated
purchasing power of these items decreases over time. Monetary assets
generate losses due to the reduction in purchasing power of cash or
future cash inflows, such as accounts receivable. Conversely,
monetary liabilities generate gains due to the reduction in purchasing
power of future cash outflows, such as accounts payable and bank debt.
Non-monetary Non-monetary items maintain their actual, intrinsic value over time.
items Examples of these items are fixed assets, long-term investments,
inventories, and equity. Since these items have been acquired some
time in the past, their historical cost is lower than their present value
in an inflationary environment.
Monetary items Since monetary items are already expressed at their present value, no
reflected in monetary correction should be calculated for the purpose of disclosure
the Income in the balance sheet. On the other hand, since assets generate monetary
Statement losses and liabilities generate monetary gains, these variances should be
calculated and reclassified on the income statement.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-29
Example For example, let's examine the transactions for one specific month,
based on the following assumptions:
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1-30 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Earnings
Balances impact Balances
Account before MC MC adjustments after MC
You can see that the company reports a gain on net monetary items of
6 Lcy, which is the net result of:
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-31
Non-monetary Since there are no monetary gains or losses from non-monetary items,
items monetary correction of these items will not affect the income
statement. However, since they were acquired in the past, the asset or
equity balance for each of these items should be restated to current
price levels in the balance sheet.
Remunerated In countries where inflation has been constant for a long time, it is
monetary items difficult to find true monetary items. Most assets and liabilities are
protected from inflation with instruments and contracts that adjust
their values according to the official inflation indices. These are
remunerated monetary items.
Similarly, for a loan in foreign currency, the company has to pay the
interest, which is the actual financial expense, and also the exchange
variances. All exchange losses incurred on this loan should be
reclassified from Financial Expense to Losses on Monetary Items.
Discounting Since credit sales include expected future inflation, they should be
receivables / adjusted as follows. Accounts Receivable in the seller's books should
payables to be discounted to present value and the difference adjusted to Net
present value Sales. Payables in the buyer's books should be discounted to present
value and the difference adjusted to Inventories.
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1-32 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Companies not For companies not listed in the stock exchange, the GAAP governing
on the stock monetary correction of financial statements as specified by the
exchange “Corporations Law” is less complete. In these cases, only Permanent
Assets and Equity accounts are monetarily corrected, with the
difference between original and restated value grouped under the
heading of Result of the Monetary Correction of the Balance Sheet.
For comparison purposes, income for the current year and the
previous year's figures are not restated.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-33
Used by banks For many years, virtually all banks have used a financial analysis
to “spread” spreadsheet to “spread” client financial numbers into a more
client financial manageable, useful, and standardized format. The spreadsheet captures
numbers client information in separate columns for each year or period,
thereby facilitating comparison and enabling trend analysis.
n A balance sheet
n An income statement
Before the arrival of the personal computer in the early 1980s, this
process was done entirely by hand on a sheet of paper. Now, it is done
electronically on a computer screen using sophisticated software
(such as Microsoft Excel), enabling a tremendous jump
in productivity and depth over earlier manual processes.
Changed 07/02/96
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1-34 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Citibank In late 1995, after many years of using a standard format either on
electronic paper or by electronic means derived from the original manual format,
spreadsheet Citibank in Latin America developed a new and more comprehensive
model electronic spreadsheet model. The new model goes beyond capturing
numbers for analysis; it incorporates business risk assessment and
financial risk rating. It also features indexing of accounts and includes
greater detail in certain account reconciliations and ratio calculations.
Know how the To make optimal use of these formats, the analyst should clearly
model works understand the details and nuances of how they work. Calculations are
the result of formulas, not magic, and it is important to understand that
designing a model involves some trade offs. As
we discuss ratios in a later unit, you will see that there may be more
than one way to calculate a ratio. Some calculations give more
accurate results than others; but, if the necessary information is
unavailable, we may have to settle for a second choice.
In certain cases, the method used for calculating a ratio may make
a significant difference in the results. It is up to the analyst to get
the additional information and make the appropriate calculations to
achieve a more in-depth, meaningful financial analysis. The analyst
must understand where the numbers come from and where the weak
points of the model may leave results open to questionable
interpretation.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-35
Summary
Problems In periods of high inflation, the balance sheet may reflect historical
values, present value, or future value. As a result, accounts may be
either overstated or understated.
Remunerated When inflation has been constant for a long time, assets and liabilities
monetary items must be protected with instruments requiring compensation for
variance in the official inflation indices to
prevent the loss of value.
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1-36 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
Adjustments When receivables and payables include expected future inflation, they
to expected should be discounted to present value and adjusted to Net Sales and
inflation Inventories, respectively, to reflect the actual value of the obligation.
Restatement for Comparative financial statements from the previous year should be
comparative restated to reflect the annual variation in the official inflation index
analysis for purposes of comparative analysis.
You have completed Unit One: Accounting Issues in Financial Analysis. Please answer the
questions in Progress Check 1.2 to check your understanding of the material before
proceeding to Unit Two: Basic Concepts of Financial Analysis.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-37
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary
correction for that year is 250%, and losses are adjusted to official inflation
indices, we may say that the company owes:
____ a) $250 at the end of the year and has incurred a remuneration of $150
(expense).
____ b) $250 at the end of the year and has been remunerated $150 (income).
____ c) $350 at the end of the year and has been remunerated $250 (income).
____ d) $350 at the end of the year and has incurred a remuneration of $250
(expense).
Question 11: Read the following statements about constant currency accounting then
indicate whether they are true or false by marking with a "T" or "F."
____ a) The nominal value of monetary items remains constant over time.
____ b) Accounts payable are non-monetary items.
____ c) Inventories are monetary items.
____ d) Non-monetary items maintain their actual (intrinsic) value.
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1-38 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
Question 10: If a company takes a $100 loan at the beginning of 19X0, monetary
correction for that year is 250%, and losses are adjusted to official inflation
indices, we may say that the company owes:
d) $350 at the end of the year and has incurred a remuneration of $250
(expense).
Question 11: Read the following statements about constant currency accounting then
indicate whether they are true or false by marking with a "T" or "F."
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-39
____ a) the total of trade receivables undergoes monetary correction every month,
and the difference is accounted for as financial income.
____ b) the amount of the bill remains the same until payment.
____ c) after 60 days, the company records a loss caused by inflation for
the period.
____ d) there are no inflation gains or losses, since the company could sell
for cash and invest the proceeds in the money market.
____ a) Inflation gains and losses do not necessarily reflect cash inflows and
outflows during the year in which they occur.
____ b) The values of inventories which remain with the company for long periods
are lower than current market prices.
____ c) Monetary correction of remunerated liabilities generates financial
expense.
____ d) Effects of inflation are the net of gains and losses on monetary items.
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1-40 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
T a) Inflation gains and losses do not necessarily reflect cash inflows and
outflows during the year in which they occur.
T b) The values of inventories which remain with the company for long periods
are lower than current market prices.
T c) Monetary correction of remunerated liabilities generates financial
expense.
T d) Effects of inflation are the net of gains and losses on monetary items.
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-41
Use the information which follows to complete both Questions 14 and 15.
Question 14: Fill in the blanks on the following calculation of the effects of inflation.
Assume that:
n The inflation index for the period is 10%
n Both the marketable securities and loans payable are subject to monetary
correction
Opening balances:
Assets Liabilities
Cash 60 Accounts Payable 160
Marketable Securities 100 Loans 300
Fixed Assets 780 Equity 480
Calculations:
Gains on remunerated monetary assets ____________
Losses on remunerated monetary liabilities (___________)
Represented by:
Losses on non-remunerated monetary assets (___________)
Gains on non-remunerated monetary liabilities ____________
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1-42 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
Question 14: Fill in the blanks on the following calculation of the effects of inflation.
Assume that:
n The inflation index for the period is 10%
n Both the marketable securities and loans payable are subject to monetary
correction
Opening balances:
Assets Liabilities
Cash 60 Accounts Payable 160
Marketable Securities 100 Loans 300
Fixed Assets 780 Equity 480
Calculations:
Gains on remunerated monetary assets 10
Losses on remunerated monetary liabilities ( 30 )
Represented by:
Losses on non-remunerated monetary assets ( 6 )
Gains on non-remunerated monetary liabilities 16
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ACCOUNTING ISSUES IN FINANCIAL ANALYSIS 1-43
Question 15: After all adjustments are made, the balance sheet will appear as follows:
Assets Liabilities
Cash _____ Accounts Payable _____
Marketable Securities _____ Loans _____
Fixed Assets _____ Equity _____
Question 16: Select three features of the electronic spreadsheet model developed by
Citibank in Latin America.
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1-44 ACCOUNTING ISSUES IN FINANCIAL ANALYSIS
ANSWER KEY
Question 15: After all adjustments are made, the balance sheet will appear as follows:
Assets Liabilities
Cash 60 Accounts Payable 160
Marketable Securities 110 Loans 330
Fixed Assets 858 Equity 538
Composition of Equity
Opening Balance 480
+ Monetary Correction 48
+ Net Income 10
Question 16: Select three features of the electronic spreadsheet model developed by
Citibank in Latin America.
e) Account indexing
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Unit 2
UNIT 2: BASIC CONCEPTS OF FINANCIAL ANALYSIS
INTRODUCTION
In Unit One, we discussed some of the accounting issues that affect the preparation of
financial statements. By now, you should recognize that financial analysts must “get
behind the numbers” by considering certain accounting-related issues to understand the
true financial picture of a company. In this unit, we will focus on other areas of
consideration, including analyzing the funds flow within a company and measuring its
working capital needs. These basic concepts will enable you, the analyst, to probe
deeper in search of more reliable conclusions concerning a company's financial health.
UNIT OBJECTIVES
n Classify assets, liabilities, and net worth accounts as either a use or source of
funds
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2-2 BASIC CONCEPTS OF FINANCIAL ANALYSIS
LIQUIDITY
Degree of Liquidity
The seasonality of an item may also affect its liquidity; for example, a
heavy coat will be more marketable during the winter season than in
the hot summer months.
Importance of Liquidity
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-3
Increasing Liquidity
Liquidity also affects the structure of the balance sheet. The asset
accounts are listed in the order of their liquidity — current assets
first, fixed assets second, and other assets last. Individual current
accounts are also ranked by their degree of liquidity. For instance,
cash is the most liquid account and is, therefore, listed first among the
current assets.
TYPES OF CAPITAL
Working Capital
In general, the greater the amount of working capital, the greater the
liquidity. In Unit Four, we will demonstrate that the current ratio,
which represents the coverage of current assets over current
liabilities, is a traditional measure of liquidity.
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2-4 BASIC CONCEPTS OF FINANCIAL ANALYSIS
Working capital In Figure 2.1, you can see the concept of working capital from
from the funds the funds flow perspective of how funds actually flow within a
flow perspective company. We will discuss funds flows in greater detail later in
this unit.
Supplier Payroll
Inventories
Income
Cash Receivables
Bank Loans
Working capital flows are not homogeneous; funds flow in and out in
different volumes and at different times in response to seasonality of
sales, purchases, and work flow.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-5
Figure 2.2: Positive working capital — current assets > current liabilities
Figure 2.3: Negative working capital — current assets < current liabilities
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2-6 BASIC CONCEPTS OF FINANCIAL ANALYSIS
Permanent Capital
LIABILITIES &
ASSETS NET WORTH
We know that net worth is the interest investors have in the assets of
an enterprise after satisfaction of liabilities owed to the company's
creditors. Net worth represents an important part of a company's
permanent capital and should be used to support fixed assets and
investments. Any excess of net worth over fixed and other non-current
assets is then available for funding working capital.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-7
Notice that there is a $50 difference between net worth and fixed
assets. Since net worth is greater, the difference ($50) in effect serves
to provide funds for working capital. The proportion of a company’s
own resources used for funding fixed assets is greater than 100%, so
14% of net worth is used to fund the company's working capital.
Now suppose Alpha Company purchases a new plant for $100 that is
financed by long-term loans.
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2-8 BASIC CONCEPTS OF FINANCIAL ANALYSIS
Own Capital
Own capital represents the owners' investment in the company plus the
wealth accumulated by the company from its business earnings. It is
divided into:
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-9
Paid-in Capital
Own Capital
Retained Earnings
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2-10 BASIC CONCEPTS OF FINANCIAL ANALYSIS
SUMMARY
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-11
n Own capital
Own capital represents the owners' investment in the company and the
accumulated wealth generated from doing business. Own capital
includes:
n Paid-in capital
n Retained earnings
Distinctions between third party capital and own capital are important
because of the obligations and privileges associated with them. Third
party capital is an obligation to be paid, while paid-in capital carries
incidence of ownership and the right to profits.
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2-12 BASIC CONCEPTS OF FINANCIAL ANALYSIS
You have completed the first section of Unit Two. Please complete
Progress Check 2.1 before continuing to the final section of this unit
which covers “Sources and Uses of Funds.”
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-13
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
____ a) cost.
____ b) market value.
____ c) degree of convertibility to cash.
____ d) age.
Question 3: Number the following assets (1-3) to indicate the degree of liquidity.
(1 for most liquid)
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2-14 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 3: Number the following assets (1-3) to indicate the degree of liquidity.
(1 for most liquid)
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-15
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2-16 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
d) bankruptcy.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-17
Question 5: Look at the following list of funds movements that relate to working capital.
Write the letter of each item in the appropriate circle in the diagram below.
The first one serves as an example.
CASH
PAYROLL
FINISHED GOODS
CUSTOMERS
SALES
COMMISSIONS PAID
TO SALESPERSONS
PROFITS
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2-18 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 5: Look at the following list of fund movements that relate to working capital.
Write the letter of each item in the appropriate circle in the diagram below.
The first one serves as an example.
CASH
j PAYROLL b
d
g l
k FINISHED GOODS
CUSTOMERS e SALES
m
COMMISSIONS PAID
TO SALESPERSONS
f
PROFITS
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-19
Question 6: Look at the current assets and current liabilities from the balance sheet
of ABC, Inc. Using this information, calculate the working capital for
each year.
ABC, Inc.
19X1 19X2
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2-20 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 6: Look at the current assets and current liabilities from the balance sheet
of ABC, Inc. Using this information, calculate the working capital for
each year.
19X1 19X2
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-21
Question 7: Look at the following list of movements that relate to permanent capital.
Write the letter for each item in the appropriate circle in the diagram below.
SHAREHOLDERS
MACHINERY AND
STOCK IN OTHER EQUIPMENT
COMPANIES
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2-22 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 7: Look at the following list of movements that relate to permanent capital.
Write the letter for each item in the appropriate circle in the diagram below.
SHAREHOLDERS f
b
c
MACHINERY AND
STOCK IN OTHER EQUIPMENT
COMPANIES
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-23
Question 8: Classify the following accounts as either (T) third party capital or (O) own
capital. The first one serves as an example.
Question 9: Classify the following accounts as either (O) operating credits or (F)
financial credits.
____ Loans
____ Accrued taxes
____ Debenture bonds
____ Trade bills
____ Accrued payroll and payroll taxes
____ Inter-company credits
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2-24 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 8: Classify the following accounts as either (T) third party capital or (O) own
capital. The first one serves as an example.
Question 9: Classify the following accounts as either (O) operating credits or (F)
financial credits.
F Loans
O Accrued taxes
F Debenture bonds
O Trade bills
O Accrued payroll and payroll taxes
F Inter-company credits
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-25
Question 10: Study the liabilities of the following companies and fill in the blanks below.
COMPANY A COMPANY B
Liabilities & Net Worth Liabilities & Net Worth
e) The own capital of Company is higher than the own capital of Company .
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2-26 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 10: Study the liabilities of the following companies and fill in the blanks below.
COMPANY A COMPANY B
Liabilities & Net Worth Liabilities & Net Worth
e) The own capital of Company B is higher than the own capital of Company A .
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-27
Assets as Some uses of funds are obvious. For example, a company uses funds
funds uses to increase assets, such as the purchase of inventories or a new plant
building. However, not all uses of funds are so obvious; a company
may use funds to extend credit to its customers, or just to increase its
bank balances.
Liabilities and The funds used to purchase or acquire assets are sourced from bank
net worth as loans, supplier credit, stockholders' equity, etc. These sources of
funds sources funds are the liabilities and net worth accounts listed in the balance
sheet. This concept is illustrated in Figure 2.6.
LIABILITIES &
Sources of Funds
NET WORTH
Taking a closer look, you can see that assets, liabilities, and net
worth can be both sources and uses of funds. In Figure 2.7, we
show that assets can be sources if they are reduced — e.g., reducing
a checking account balance to purchase a property. In this example, one
asset account (cash) is reduced in exchange for another asset account
(property), but the total assets remain the same.
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2-28 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ASSETS
Figure 2.7: Assets, liabilities, and net worth can be both uses and
sources of funds
On the asset side of the balance sheet, the purchase of an asset is a use
of funds; sale of an asset is a source of funds. On the liabilities and net
worth side of the balance sheet, an increase in liabilities or net worth
is a source of funds; a reduction in liabilities or net worth is a use of
funds. A use of fund, therefore, is an increase in an asset account or a
decrease in a liability or net worth account. Conversely, a source of
funds is a decrease in an asset or an increase in a liability or equity
account.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-29
BALANCE SHEET
LIABILITIES &
ASSETS NET WORTH
Use of Funds: (+) Increase (-) Decrease
Source of Funds: (-) Decrease (+) Increase
Figure 2.8: Effect on the balance sheet of uses and sources of funds
Operating / Non-Operating
We have seen that changes in assets, liabilities, and net worth accounts
can be identified as sources or uses. Let’s add another concept to this.
These changes also can be identified as operating sources / uses or
non-operating sources / uses, depending on the
type of account.
Normal day-to- Operating sources and uses refer to those assets and liabilities
day operations principally associated with the normal day-to-day operations of the
of the company company. These are basically current assets or current liabilities, with
some exceptions. We do not include cash or cash equivalent assets
within the current assets and we do not include short-term bank debt
within the current liabilities. You will see the reason for these
exclusions as you continue to read.
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2-30 BASIC CONCEPTS OF FINANCIAL ANALYSIS
All other Non-operating sources and uses pertain to practically all other assets,
accounts liabilities, and equity accounts, including one of the exceptions listed
above — short-term bank debt. The most common examples are:
n Dividends
First, let’s consider the income statement from the sources / uses
perspective as well.
Sales revenues Sources and uses of funds also appear in the income statement: sales
vs. costs and represent revenues, which are sources of funds; costs and expenses
expenses represent uses of funds. The net result of revenues minus expenses
is either a profit (a source of funds) or a loss (a use of funds). The
flows are the same for all companies, but volumes of funds,
maturities, and realization times will vary from firm to firm.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-31
INCOME STATEMENT
Revenue (+) Source of Funds
Expense (-) Use of Funds
Gross operating Putting all this together, we can construct a funds generation
funds statement. We start with net income (the net sources from the income
generation statement) and add depreciation to obtain gross operating funds
generation. We also add other non-cash charges, if there
are any.
Net operating Next, we subtract operating uses and add operating sources to
funds determine net operating funds generation. This is the most
generation important number because it tells the analyst the amount of funds the
company has generated (or will be generating if the numbers are
projections) to pay bank debt and dividends, and contribute to other
non-operating needs such as plant and equipment expenditures.
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2-32 BASIC CONCEPTS OF FINANCIAL ANALYSIS
Free operating Note that the new Citibank spreadsheet now includes a certain portion
cash flow of plant and equipment expenditures in a special maintenance category
to reflect that P+E must normally be replenished to maintain existing
operational levels. Subtracting maintenance capital expenditures
from net operating funds generation results in the figure for free
operating cash flow.
Increase / The final number must be close to the increase or decrease in cash
decrease in and cash equivalent accounts from one accounting period to the
cash and cash other. This is the check on the exercise. If the numbers do not check,
equivalent a mistake has been made by inputting incomplete or incorrect data.
+ Net income
+ Depreciation
+ Other non-cash charges
= Gross operating funds generation
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-33
FUNDS
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2-34 BASIC CONCEPTS OF FINANCIAL ANALYSIS
SUMMARY
Sources and uses of funds are also reflected in the income statement.
Sales (revenues) represent sources of funds, whereas costs and
expenses represent uses of funds.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-35
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
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2-36 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-37
Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The
first one serves as an example.
S Capital increase
Supplier payments
Raw materials purchases
Bank loans
Collection of trade bills
Advances from customers
Dividend payments
Net income
Purchase of marketable securities
Profit on real estate sales
Tax payments
Purchase of affiliates' shares
Payroll disbursements
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2-38 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 12: Identify the following as either a (S) source of funds or (U) use of funds. The
first one serves as an example.
S Capital increase
U Supplier payments
U Raw materials purchases
S Bank loans
S Collection of trade bills
S Advances from customers
U Dividend payments
S Net income
U Purchase of marketable securities
S Profit on real estate sales
U Tax payments
U Purchase of affiliates' shares
U Payroll disbursements
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-39
Question 13: Look at the example and fill in the statements below:
Purchase Consumption
INVENTORIES
Use Source
$300 $200
Question 14: Look at the example and fill in the statements below:
c) The resulting balance of $ from the above transactions represents the net amount
of resources which remain in use to finance customers.
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2-40 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 13: Look at the example and fill in the statements below:
Purchase Consumption
INVENTORIES
Use Source
$300 $200
c) The balance of inventories, $ 100 , represents the net amount of resources applied in
inventories.
Question 14: Look at the example and fill in the statements below:
a) The increase in trade receivables generated by sales on credit totals $ 150 and is a
use of funds because the company uses its resources to finance its clients.
c) The resulting balance of $ 50 from the above transactions represents the net amount
of resources which remain in use to finance customers.
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-41
Question 15: Look at the example and fill in the statements below:
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2-42 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 15: Look at the example and fill in the statements below:
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-43
Question 16: The following flowchart shows the movement of funds among several
balance sheet accounts. Indicate whether each item is a (U) use of funds or
(S) source of funds and enter the balance for each account.
$5 $ 135
SHAREHOLDERS SUPPLIERS
$ 50
CASH $ 200
$ 100
b) SUPPLIERS e) SHAREHOLDERS
( ) $200 ( ) $50
( ) 135 ( ) 5
Balance ( ) $ Balance ( ) $
c) INVENTORIES
( ) $200
( ) 150
Balance ( ) $
USES SOURCES
Cash $ Suppliers $
Trade Receivables $ Shareholders $
Inventories $
TOTAL $ TOTAL $
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2-44 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 16: The following flowchart shows the movement of funds among several
accounts. Indicate whether each item is a (U) use of funds or (S) source of
funds and enter the balance for each account.
$5 $ 135
SHAREHOLDERS SUPPLIERS
$ 50
CASH $ 200
$ 100
b) SUPPLIERS e) SHAREHOLDERS
( S ) $200 ( S ) $50
( U ) 135 (U) 5
Balance ( S ) $ 65 Balance ( S ) $45
c) INVENTORIES
( U ) $200 Remember, cash in hand is an asset and, therefore, a
( S ) 150 use of funds. Reduction of cash is a source of funds
Balance ( U ) $ 50 to reduce debt or other obligations of the enterprise.
USES SOURCES
Cash $ 10 Suppliers $ 65
Trade Receivables $ 50 Shareholders $ 45
Inventories $ 50
TOTAL $ 110 TOTAL $ 110
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BASIC CONCEPTS OF FINANCIAL ANALYSIS 2-45
Question 18: Consider the following funds movements and arrange them in order
to calculate:
Gross operating funds generation __________
Net operating funds generation __________
Free operating funds generation __________
Net increase / decrease in cash and cash equivalent __________
Funds Movements:
Increase in accounts payable 200 Increase in inventory 400
Increase in accounts receivable 300 Other non-cash charges 100
Maintenance P+E expenditures 200 Payment of long-term bank debt 100
Depreciation 150 Increase in accruals 100
Dividends 100 Expansionary P+E expenditures 200
Net income 500 Increase in short-term bank debt 200
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
___________________________________________ ____________
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2-46 BASIC CONCEPTS OF FINANCIAL ANALYSIS
ANSWER KEY
Question 18: Consider the following funds movements and arrange them in order
to calculate:
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Unit 3
UNIT 3: FINANCIAL STATEMENT ANALYSIS
INTRODUCTION
UNIT OBJECTIVES
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3-2 FINANCIAL STATEMENT ANALYSIS
Imposed by Financial statements conform to certain rules and standards that allow
rules and for easy reading and comprehension. These rules also impose some
standards limitations for a correct financial statement interpretation that may
affect credit decisions.
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FINANCIAL STATEMENT ANALYSIS 3-3
Factors to In addition to the limits imposed by the rules and standards for
consider preparing financial statements, analysts must recognize that financial
statements reflect only a portion of a company's condition. The
analyst must also consider the issues associated with Citibank’s
business risk assessment process, including:
n Economic environment
n Market conditions
n Type of business
n Management
Economic Environment
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3-4 FINANCIAL STATEMENT ANALYSIS
Market Conditions
Type of Business
2) What are the norms in the economic sector for trade terms?
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FINANCIAL STATEMENT ANALYSIS 3-5
Management
You have just completed the first section of Unit Three. Please
complete the following Progress Check before continuing to the next
section, "Analysis Techniques."
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3-6 FINANCIAL STATEMENT ANALYSIS
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FINANCIAL STATEMENT ANALYSIS 3-7
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 1: Indicate whether the following statements are (T) true or (F) false.
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3-8 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
Question 1: Indicate whether the following statements are (T) true or (F) false.
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FINANCIAL STATEMENT ANALYSIS 3-9
ANALYSIS TECHNIQUES
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3-10 FINANCIAL STATEMENT ANALYSIS
VERTICAL ANALYSIS
Purpose
Balance Sheet
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FINANCIAL STATEMENT ANALYSIS 3-11
Rounding off to the nearest whole number, we find that the cash
account for 19X0 has a 3% share of total assets. The same analysis is
applied to the other asset accounts and to the liability and net worth
accounts. The results, expressed as percentages, can then be
compared from year to year. This comparative analysis is useful since
it highlights relative account movements that absolute figures may
not detect.
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3-12 FINANCIAL STATEMENT ANALYSIS
Income Statement
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FINANCIAL STATEMENT ANALYSIS 3-13
Summary
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3-14 FINANCIAL STATEMENT ANALYSIS
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FINANCIAL STATEMENT ANALYSIS 3-15
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 2: Write the letter of the definition next to the type of analysis it describes.
c) Creates assumptions about funding needs in the future based on cash generation
capabilities
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3-16 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
Question 2: Write the letter of the definition next to the type of analysis it describes.
e Vertical analysis
d Horizontal analysis
b Financial ratio analysis
a Operating / non-operating funds generation analysis
c Trends analysis and financial projection
c) Creates assumptions about funding needs in the future based on cash generation
capabilities
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FINANCIAL STATEMENT ANALYSIS 3-17
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FINANCIAL STATEMENT ANALYSIS 3-19
Question 3: Based on the vertical analysis of the financial statements of Jurure Company,
complete the following questions.
b) The percentage of own and outside capital in 19X0 and 19X1 is:
19X0 19X1
Outside Capital _____% _____%
Own Capital _____% _____%
Total Liabilities & Net Worth 100% 100%
c) The share of own capital from 19X0 to 19X1 increased from ____% to ____%. This
shows that the increase in own resources was proportionally (larger / smaller)
_________________ than the increase in outside resources.
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3-20 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
Question 3: Based on the vertical analysis of the financial statements of Jurure Company,
complete the following questions.
b) The percentage of own and outside capital in 19X0 and 19X1 is:
19X0 19X1
Outside Capital 55% 45%
Own Capital 45% 55%
Total Liabilities & Net Worth 100% 100%
c) The share of own capital from 19X0 to 19X1 increased from 45% to 55% . This
shows that the increase in own resources was proportionally larger than the increase in
outside resources.
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FINANCIAL STATEMENT ANALYSIS 3-21
19X0 % 19X1 %
Net Sales 3,000 100 5,100 100
– Cost of Goods Sold 1,280 43 2,460 48
– SGA Expenses 480 16 1,071 21
Operating Profit 1,240 41 1,569 31
– Depreciation 220 7 345 7
– Financial Expense 510 17 510 10
+ Financial Income 180 6 255 5
Earnings Before Tax 690 23 969 19
– Income Tax 240 8 408 8
Net Income 450 15 561 11
b) In 19X1 , operating profit decreased on a relative basis because net sales increased
________ than cost of goods sold.
____ faster
____ slower
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3-22 FINANCIAL STATEMENT ANALYSIS
Question 4: (Continued)
d) In 19X1, there was a(n) ______________ in financial expense in relation to net sales.
____ increase
____ decrease
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FINANCIAL STATEMENT ANALYSIS 3-23
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3-24 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
b) In 19X1 , operating profit decreased on a relative basis because net sales increased
slower than cost of goods sold.
d) In 19X1 , there was a(n) decrease in financial expense in relation to net sales.
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FINANCIAL STATEMENT ANALYSIS 3-25
HORIZONTAL ANALYSIS
Purpose
Evaluate trends Horizontal analysis is a technique used to evaluate trends over time by
over time computing percentage increases or decreases relative to a base year. It
provides an analytical link between accounts calculated at different
dates using currency with different purchasing powers. In effect, this
analysis indexes the accounts and compares the evolution of these
over time.
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3-26 FINANCIAL STATEMENT ANALYSIS
Technique
Comparing two To compute the percentage of increase compared to the prior year, we
time periods calculate the percentage growth for each account and subtract 100.
For example:
Comparing When a horizontal analysis involves more than two periods, the basis
more than two may be defined as the preceding period for each successive period of
time periods analysis, as in the above example — 19X1 compared to 19X0; 19X2
compared to 19X1. Another possibility is to define the basis as the
growth in following periods measured against a designated base year,
as below — both 19X1 and 19X2 compared to 19X0:
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FINANCIAL STATEMENT ANALYSIS 3-27
Sales Growth
Key account Net sales is one of the most important individual accounts to be
to analyze analyzed by the horizontal methodology. It is a universal part of
financial analysis and often is the only account measured in terms of
percentage growth from one year to another.
The calculation of the sales growth rate is the same as the normal
horizontal technique. If we assume net sales of 1,000 in 19X0 and
of 1,200 in 19X1, the sales growth is:
Increased sales When we analyze the net sales growth figure, it is important to
vs. inflation determine how much of the increase is due to inflation and how much
is due to increased unit sales. An apparently strong sales increase
from one period to another could be entirely due to inflation. In fact,
volume sales could drop from one period to another, but increased
pricing could mask the drop as a reported sales increase in monetary
terms.
Increased sales You can also judge whether a company's sales are growing fast enough
vs. competitors by comparing them to the growth of sales for the industry as a whole.
If the real growth is eight percent for a certain sector, and
a firm within this sector experiences a volume sales growth of only
three percent, then this indicates a loss of market share. So, sales
growth helps measure the performance of a company over time and
also its performance relative to the performance of its competitors.
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3-28 FINANCIAL STATEMENT ANALYSIS
Assumptions for The sales growth rate is also very important for compiling projected
future growth financial statements for a firm because it is the starting point for the
projection exercise. The sales growth assumption determines the
projected sales level which leads to other assumptions that determine
the rest of the income statement, then the current asset levels, and
finally, the rest of the balance sheet.
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FINANCIAL STATEMENT ANALYSIS 3-29
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 5: Compute percentage increases and decreases in current assets for the
Cristina Company.
31 DEC 19X0 31 DEC 19X1 %
Cash $ 30 $ 40 ___
Marketable Securities 180 120 ___
Trade Receivables 240 380 ___
Inventories 150 440 ___
Current Assets $ 600 $ 980 ___
Question 6: Compare the percentage growths in the income statement for Cristina
Company and answer the questions below.
31 DEC 19X0 31 DEC 19X1 %
Sales $ 1,400 $ 1,800 29
Cost of Goods Sold 900 1,080 20
SGA Expenses 200 280 40
Operating Income $ 300 $ 440 47
Financial Expense 90 160 78
Other Expense 40 70 75
Earnings Before Tax 170 210 24
Income Tax 40 60 50
Net Income 130 150 15
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3-30 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
Question 5: Compute percentage increases and decreases in current assets for the
Cristina Company.
Question 6: Compare the percentage growths in the income statement for Cristina
Company and answer the questions below.
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FINANCIAL STATEMENT ANALYSIS 3-31
Question 7: Based on the summary of accounts for Cristina Co. and the numbers in
Question 5, indicate whether the following statements are (T) true or (F)
false.
____ a) Sales grew by 29%, jeopardizing both profit margins and liquidity.
____ b) Current assets grew faster than sales, mainly due to a build up of
inventories.
____ c) Net income grew less than sales because expenses grew faster.
Question 8: A strong net sales growth figure may be misleading if it primarily results
from:
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3-32 FINANCIAL STATEMENT ANALYSIS
ANSWER KEY
Question 7: Based on the summary of accounts for Cristina Co. and the numbers in
Question 5, indicate whether the following statements are (T) true or (F)
false.
Question 8: A strong net sales growth figure may be misleading if it primarily results
from:
b) inflation.
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Unit 4
UNIT 4: FINANCIAL RATIOS — LIQUIDITY
INTRODUCTION
An analyst uses financial ratios to understand the relationships among various financial
statement accounts. These ratios yield information about a company’s ability to meet short-
term obligations on time, remain solvent over a long period, manage assets, and operate
efficiently.
In this unit, we demonstrate the calculation of two liquidity ratios: the current ratio and the
acid test (or quick asset) ratio. The current ratio tells us the amount of current assets that
are available to cover current liabilities. The acid test accomplishes the same purpose as the
current ratio, but it yields more precise information because it considers only the most
liquid assets. Finally, we will look at two situations that demonstrate how a company’s
decisions can affect its liquidity ratios.
UNIT OBJECTIVES
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4-2 FINANCIAL RATIOS — LIQUIDITY
FINANCIAL RATIOS
Relationships The use of ratios and margins in financial analysis enables the analyst
within accounts to interpret the financial situation of an enterprise in a more
meaningful manner than by just looking at the absolute numbers.
Financial ratios consider the relationships that exist within various
accounts and, thus, facilitate an understanding of a company’s financial
condition with greater depth and clarity.
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FINANCIAL RATIOS — LIQUIDITY 4-3
LIQUIDITY RATIOS
n Current ratio
Current Ratio
Current Assets
Current Ratio =
Current Liabilities
A rule of thumb is that a current ratio close to 2.0 is good, but this is a
very generalized statement. Let's look at an example.
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4-4 FINANCIAL RATIOS — LIQUIDITY
Company C has $2.22 in current assets for each $1.00 in current debt.
It apparently has more liquidity and, therefore, appears to
be in a better position to pay its short-term debts than either Company
A or B.
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FINANCIAL RATIOS — LIQUIDITY 4-5
Example: The shoe producer has major needs for inventory — both raw
Shoe producer materials and finished goods — because the nature of the business
is to produce many styles, sizes, and colors. In the real world, the shoe
company must also sell on a credit basis to entice shoe stores
to purchase its product. The business can, thus, be considered working
capital intensive. In such cases, a significant portion of the company’s
own capital may be invested in financing working capital needs —
since suppliers will not finance either finished goods or receivables.
The shoe producer’s probable current ratio is around 1.5, or maybe a
little higher.
Example: The supermarket sells on a cash basis and, therefore, does not have
Supermarket a need to book receivables. The supermarket chain is also in a strong
chain position on purchasing and can often negotiate longer credit terms
than needed. The supermarket may take 60 day terms and turn over the
goods in 30 days, investing the funds for the other 30 days. The
supermarket chain’s probable current ratio is around 1.0, since there is
little or none of the supermarket’s own capital invested in current
assets.
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4-6 FINANCIAL RATIOS — LIQUIDITY
Acid Test
Considers most The second commonly used liquidity ratio is the quick asset ratio,
liquid current often called the acid test. This ratio presents a more precise liquidity
assets test by considering only the more liquid current assets, thereby
excluding inventories, prepaid expenses, and other current assets from
the calculation. In this way, the index places greater emphasis on the
more immediate conversion of current assets to provide coverage of
short-term obligations. The rule of thumb for a healthy acid test index
is 1.0.
The acid test presumes that trade receivables are more liquid than
inventories. Trade receivables are directly converted to cash;
inventories are first converted to trade receivables (if sales are
made on a credit basis) and then to cash. In addition, there is some
uncertainty of the value at which inventories will be realized, since
some items may become damaged, lost, or obsolete.
Two ratios are Let's look at the current ratio example and see how the two ratios
complementary complement each other.
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FINANCIAL RATIOS — LIQUIDITY 4-7
Similar to the current ratio, the analyst must attempt to get behind the
acid test computed index and verify that the trade receivables
substantiating the ratio are fully realizable at the agreed upon term.
The analyst also must consider the firm's line of business since
companies that sell on a cash basis (such as supermarkets) have no
receivables on the balance sheet. The result is a very low quick asset
ratio even though the type of inventory sold (food, in the case of a
supermarket) may be very liquid. The company's liquidity situation
could be quite good despite a low acid test figure.
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4-8 FINANCIAL RATIOS — LIQUIDITY
Associated with Besides the current ratio and acid test, there may be other liquidity
levels of cash indicators. These could be associated with cash levels, such as:
The new Citibank spreadsheet includes days cash, along with days
receivable, days inventory, and days payable as liquidity ratios. This
recognizes that the turnover of these current assets is closely linked to
a company’s liquidity position.
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FINANCIAL RATIOS — LIQUIDITY 4-9
Directions: Enter the correct answers for the following questions. There is only one correct
answer unless otherwise stated in the question. Check your answers with the
Answer Key on the next page. If you answer any of the questions incorrectly,
return to the appropriate section of the text and review the material.
Question 1: Write the letter of the definition next to the type of financial ratios
it describes.
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4-10 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
Question 1: Write the letter of the definition next to the type of financial ratios
it describes.
c Liquidity ratios
d Leverage ratios
a Turnover ratios
b Profitability ratios
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FINANCIAL RATIOS — LIQUIDITY 4-11
Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current
liabilities there is $1.45 in current assets.
a) The current ratio is ___________.
b) The ratio is considered to be:
strong.
adequate.
weak.
Question 4: The current ratio only gives a rough quantitative idea of the relationship
between current assets and current liabilities because it disregards the
different payment and collection times.
____ True
____ False
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4-12 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
Question 3: The balance sheet of Toy Co., Inc., shows that for each $1.00 in current
liabilities there is $1.45 in current assets.
Question 4: The current ratio only gives a rough quantitative idea of the relationship
between current assets and current liabilities because it disregards the
different payment and collection times.
X True
False
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FINANCIAL RATIOS — LIQUIDITY 4-13
Question 5: Look at the relevant portion of the balance sheet of TWR Company.
b) The current ratio depends on the ability to sell inventories. If we exclude inventories
from current assets, liquidity falls to ____ for Company B and ____ for Company C.
c) The liquidity of Company C is more balanced since it does not depend so much on the
ability to sell inventories to meet current liabilities.
____ True
____ False
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4-14 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
Question 5: Look at the relevant portion of the balance sheet of TWR Company.
Company B Company C
Current Assets 10,600 5,100
Current Liabilities 6,500 3,800
Inventories 4,700 400
Current Ratio 1.63 1.34
Acid Test 0.91 1.24
b) The current ratio depends on the ability to sell inventories. If we exclude inventories
from current assets, liquidity falls to 0.91 for Company B and 1.24 for Company
C.
c) The liquidity of Company C is more balanced since it does not depend so much on the
ability to sell inventories to meet current liabilities.
X True
False
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FINANCIAL RATIOS — LIQUIDITY 4-15
____ b) The higher a company's liquidity ratio, the less chance it has to pay
its debts.
____ c) Current ratio shows how many dollars in current assets a company
has to meet each $1.00 in current liabilities.
____ d) The acid test shows how many dollars the company has in quick
assets to cover each $1.00 in current liabilities.
____ e) The acid test ignores inventories because of the uncertainty of their value
until realized.
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4-16 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
F b) The higher a company's liquidity ratio, the less chance it has to pay
its debts.
T d) The acid test shows how many dollars the company has in quick
assets to cover each $1.00 in current liabilities.
T e) The acid test ignores inventories because of the uncertainty of their value
until realized.
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FINANCIAL RATIOS — LIQUIDITY 4-17
Example There are many factors that can change a company's liquidity. Let's
look at the following example:
In this case, the company's current ratio is 1.20. Let's see how
different financial decisions can affect this current ratio.
Situation 1:
Short-term loan The company takes a short-term loan of $800, increasing its current
liabilities. Let's see what happens if the company uses the proceeds to
(a) purchase inventories or (b) purchase equipment.
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4-18 FINANCIAL RATIOS — LIQUIDITY
Situation 2:
Increased The owners decide to increase capital by $800, thus increasing net
capital worth. The proceeds may be used to (a) add to inventories or (b) add to
machinery.
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FINANCIAL RATIOS — LIQUIDITY 4-19
The examples demonstrate that the current ratio may vary according to
the situation. This ratio is only one source of information about a
company's financial status.
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FINANCIAL RATIOS — LIQUIDITY 4-21
Question 8: The following data reflect the situation of M&M, Inc. a few days before
balance sheet date.
Proposal A Before balance sheet date, take a short-term loan of $1,200 and
buy additional inventories.
Proposal B Before balance sheet date, take a short-term loan of $1,200 and
buy machinery and vehicles.
Proposal C After balance sheet date, take the loan and buy inventories.
Current ratio: ______
a) Proposal A
b) Proposal B
c) Proposal C
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4-22 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
Question 8: The following data reflect the situation of M&M, Inc. a few days before
balance sheet date.
ASSETS LIABILITIES & NET WORTH
Current Assets $ 8,000 Current Liabilities $ 4,000
Fixed Assets 6,000 Net Worth 10,000
TOTAL $14,000 TOTAL $14,000
Proposal B Before balance sheet date, take a short-term loan of $1,200 and
buy machinery and vehicles.
Current ratio: 1.54 i
Proposal C After balance sheet date, take the loan and buy inventories.
Current ratio: 2.00 i
a) Proposal A
b) Proposal B
X c) Proposal C
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FINANCIAL RATIOS — LIQUIDITY 4-23
Question 9: A few days before balance sheet date, Alpha Company and Beta Company
were in the following situations:
+ Beta converted marketable securities of $2,000 into cash and repaid $2,000
in current loans, thus reducing both assets and liabilities.
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4-24 FINANCIAL RATIOS — LIQUIDITY
ANSWER KEY
Question 9: A few days before balance sheet date, Alpha Company and Beta Company
were in the following situations:
Alpha Company Beta Company
Current Assets $1,500 Current Assets $6,000
Current Liabilities 1,000 Current Liabilities 4,700
+ Beta converted marketable securities of $2,000 into cash and repaid $2,000
in current loans, thus reducing both assets and liabilities.
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Unit 5
UNIT 5: FINANCIAL RATIOS — LEVERAGE
INTRODUCTION
In general, leverage ratios focus on the sufficiency of assets, or generation from assets,
to cover the company’s pending short- and long-term obligations. The liquidity ratios
discussed in Unit Four are similar in this regard but they are more concerned with the
urgency of coverage; leverage ratios are more concerned with overall volume of
coverage.
Leverage ratios, also called capital structure ratios or solvency ratios, measure the
relationship between outside capital and shareholder capital. Leverage ratios include:
UNIT OBJECTIVES
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5-2 FINANCIAL RATIOS — LEVERAGE
Calculation
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FINANCIAL RATIOS — LEVERAGE 5-3
Leverage Analysis
The amount of fixed assets on the balance sheet is one of the major
determinants of appropriate leverage. A heavy industry with major
fixed asset needs will require greater capital levels to sustain its
illiquid assets. The total debt for these types of companies will be
relatively low in comparison to net worth, resulting in relatively
low leverage levels. On the other hand, highly liquid companies
with little need for fixed assets (such as wholesalers or trading
companies) normally will operate at debt levels that are multiples
of net worth, resulting in leverage of two or three, or perhaps greater.
In Table 5.2, we show a comparison of the leverage for these two types
of companies.
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Effect of Seasonality
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FINANCIAL RATIOS — LEVERAGE 5-5
Financial Leverage
Earlier, we said that from the lender’s perspective, the lower the
leverage ratio for a company, the better. But, the borrower’s interest,
in the case of capital sufficiency, may differ from the banker’s. From
the shareholder’s point of view, if leverage is too low, profits may be
insufficient for the level of equity in the company, resulting in a poor
return on equity.
Reasonably
Aggressively
Conservative Leveraged Leveraged
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5-6 FINANCIAL RATIOS — LEVERAGE
“Correct” The “correct” leverage figure for each company, then, may vary
leverage figure considerably, depending on the liquidity of the assets, stability of the
economic sector, and factors within the market. But, it is safe
to say that the greater the amount of fixed assets, the greater the
capital needs and, therefore, the lower the normal leverage level.
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FINANCIAL RATIOS — LEVERAGE 5-7
Net of When analyzing a company’s balance sheet, keep in mind that it may
nonconvertible show assets that are difficult or impossible to convert into
assets cash, such as pre-operating expenses or other intangibles, stale
receivables, obsolete inventories, etc. These assets should be
deducted from net worth for calculating leverage in order to present a
more realistic or conservative scenario. The result of
this “write down” is called tangible net worth.
$M
Total assets 500
Current liabilities 200
Long-term liabilities 50
Net worth 300
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Revaluation Surplus
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FINANCIAL RATIOS — LEVERAGE 5-9
Other Adjustments
Operating A similar situation may occur with operating leases where the
leases acquired assets are not booked on the user company’s balance sheet.
By definition, the lease payments are expensed and there is no listed
liability. But, if we look at the case of an airline, we see that the
company cannot operate without the leased aircraft — and lease
payments are really liabilities if the company plans to keep doing
business. Omitting these “liabilities” from the balance sheet distorts
reality, overstates the capital position, and severely understates the
generic leverage of the company.
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5-10 FINANCIAL RATIOS — LEVERAGE
Unadjusted Adjusted
In the case of consolidated numbers, the auditor lists assets on the left
side, and liabilities, minority interest, and net worth accounts
on the right side of the balance sheet. But, what is minority interest? Is
it debt or equity? What should the analyst do with the minority interest
account in terms of analysis?
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FINANCIAL RATIOS — LEVERAGE 5-11
Incorrect Correct
Company A Company B
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FINANCIAL RATIOS — LEVERAGE 5-13
Fixed assets covered by own resources is the ratio that measures the
relationship between fixed assets and net worth.
SITUATION A
Current assets 200 Current liabilities 150
Fixed assets 300 Net worth 350
TOTAL 500 TOTAL 500
Percentage of There is a difference of 50 between net worth and fixed assets. Since
net worth funds net worth is greater, the difference of 50 is used to fund working
working capital capital. In other words, the proportion of fixed assets to own
resources is 86%, and the remaining 14% of net worth is used to fund
the company’s working capital.
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5-14 FINANCIAL RATIOS — LEVERAGE
Now, suppose Alpha Company purchases a new plant for 100 that is
funded by long-term loans. The new situation is:
SITUATION B
Current assets 200 Current liabilities 150
Fixed assets 400 Long-term liabilities 100
Net Worth 350
TOTAL 600 TOTAL 600
Current assets Fixed assets increase from 300 to 400 and total long-term liabilities
funded by increase by 100. Fixed assets are covered by 350 in net worth and by
outside capital 50 in long-term debt. Since the entire net worth is used to cover fixed
assets, current assets are funded entirely by outside capital.
COVERAGE RATIOS
This calculation finds the coverage existing from gross operating cash
flow ( GOCF or FFO, funds from operations) to enable payment of
interest expenses.
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FINANCIAL RATIOS — LEVERAGE 5-15
High ratio The higher the number for this ratio, the better, since it means greater
indicates ability ease of payment of interest. A number lower than one indicates an
to cover interest inability to pay out interest expense from operations, requiring non-
from operations operating sources to cover interest needs. An over-leveraged firm will
find this ratio to be low, perhaps near one, leaving it vulnerable to an
increase in interest rates or an economic downturn. Companies that
over leveraged themselves on Wall Street in the 1980s, such as
Macy’s and Bloomingdales, paid a heavy price for this, requiring
Chapter 11 protection from creditors to survive.
This ratio is similar to the previous one, but includes payment of long-
term debt as well:
This ratio is similar to the previous two, but includes payment of the
current portion of long-term debt instead of total long-term debt:
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5-16 FINANCIAL RATIOS — LEVERAGE
Here again, the higher the number for this ratio, the better, since
it means greater ease of debt service. A number lower than one
indicates an inability to pay out debt service from operations,
requiring reduction of working capital or non-operating sources
to cover interest needs. In such a case, the funding source will
probably be additional debt, if credit can be obtained. Again,
an over-leveraged firm will find this ratio to be low, leaving it
vulnerable to an increase in interest rates or an economic downturn.
This is precisely the risk of higher leverage for any company.
Summary
The analyst may have to adjust the leverage figure for a company to
account for such factors as seasonality and liquidity of the assets.
From the lender’s perspective, a lower ratio indicates lower risk.
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Any excess of net worth over fixed assets is used to fund working
capital.
You have completed Unit Five: Financial Ratios — Leverage. Please answer the questions
in Progress Check 5 to check your understanding of the material before proceeding to Unit
Six: Financial Ratios — Turnover.
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þ PROGRESS CHECK 5
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 1: Based on the data supplied by Parker Company, complete the following
statements.
Question 3: From the borrower’s point of view, the concept of financial leverage means:
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5-20 FINANCIAL RATIOS — LEVERAGE
ANSWER KEY
Question 1: Based on the data supplied by Parker Company, complete the following
statements.
Current liabilities $100,000
Long-term liabilities $ 50,000
Net worth $200,000
a) Most of the funds used by the company are provided by the owners.
b) There is $1 in own capital for each $0.75 in outside capital.
Question 3: From the borrower’s point of view, the concept of financial leverage means:
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PROGRESS CHECK 5
(Continued)
Question 4: Match the type of borrower with the general appropriate leverage figure.
Question 5: Company K and Company L make ceramic floor tiles. From the data supplied
below, complete the following statements.
Company K Company L
c) Company ____ has a stronger capital structure, because it has less outside
capital.
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5-22 FINANCIAL RATIOS — LEVERAGE
ANSWER KEY
Question 4: Match the type of borrower with the general appropriate leverage figure.
Question 5: Company K and Company L make ceramic floor tiles. From the data supplied
below, complete the following statements.
Company K Company L
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FINANCIAL RATIOS — LEVERAGE 5-23
PROGRESS CHECK 5
(Continued)
In studying these numbers, the financial analyst finds out the following:
n One week prior to the balance sheet closing, Delta discounted
receivables, with recourse, for 100.
n There is an obsolete inventory of 50 on Delta’s balance sheet.
n Fixed assets recently were revalued by 100, following dubious practices.
n Intangibles include deferred pre-operating expenses of 25.
n Intangibles also include a valuable license recently bought for 50.
n Delta is a guarantor of a weak company’s short-term debt of 100.
n Delta leases 200 in fixed assets not listed on the balance sheet, payable
in lease obligations over four years.
Calculate the appropriate adjusted leverage for Delta Company. Remember, every
adjustment to a balance sheet account has a corresponding counter entry, so you
should first adjust the entire balance sheet and then calculate leverage.
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ANSWER KEY
Question 6: Calculate the appropriate adjusted leverage for Delta Company. Remember,
every adjustment to a balance sheet account has a corresponding counter
entry, so you should first adjust the entire balance sheet and then calculate
leverage.
Cash 25 Short-term bank debt 450
Receivables 300 Payables 150
Inventory 250 Accruals 50
Fixed assets 600 Long-term debt 250
Intangibles 50 Net worth 325
1,225 1,225
Adjusted Leverage: 2.77
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PROGRESS CHECK 5
(Continued)
Question 7: Use the data supplied by Gamma and Beta to complete the following
statements.
Gamma Beta
Company Company
a) The total indebtedness ratios for Gamma and Beta are ____ and ____, respectively.
b) The current indebtedness ratios for Gamma and Beta are ____ and ____, respectively.
c) _______ Company has the better capital structure because most of its liabilities are
long-term.
Question 8: Use the data supplied below to complete the following statements.
SITUATION A SITUATION B
ASSETS LIABILITIES ASSETS LIABILITIES
Long-term Liabilities
$100
a) Is working capital the same for both situations? ____ (Yes / No)
b) Situation ____ uses a portion of outside resources to cover fixed assets.
c) Situation ____ shows a portion of stockholders' resources funding working capital.
d) Situation A uses ____ % of own resources to fund fixed assets.
e) Situation A uses ____ % of own resources to fund current assets.
f) Situation B uses ____ % of own resources to fund fixed assets. The remainder of fixed
assets is funded by _____________ resources.
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ANSWER KEY
Question 7: Use the data supplied by Gamma and Beta to complete the following
statements.
Gamma Beta
Company Company
Current liabilities $ 250,000 $ 158,000
Long-term liabilities $ 50,000 $ 160,000
Net worth $ 230,000 $ 241,000
a) The total indebtedness ratios for Gamma and Beta are 1.30 and 1.32 , respectively
b) The current indebtedness ratios for Gamma and Beta are 1.09 and 0.66 , respectively.
c) Beta Company has the better capital structure because most of its liabilities are long-
term.
Question 8: Use the data supplied below to complete the following statements.
SITUATION A SITUATION B
ASSETS LIABILITIES ASSETS LIABILITIES
Long-term Liabilities
$100
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PROGRESS CHECK 5
(Continued)
Question 9: The calculation for the funds from operations interest coverage ratio is:
Question 10: If the debt service ratio is less than one, which of the following may be
sources of repayment of the debt? (You may select more than one answer.)
____ a) Operations
____ b) Reduction in receivables
____ c) Reduction in inventory
____ d) Additional bank debt
Question 11: From the lender’s point of view, which of the following is the best
combination?
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5-28 FINANCIAL RATIOS — LEVERAGE
ANSWER KEY
Question 9: The calculation for the funds from operations interest coverage ratio is:
Question 10: If the debt service ratio is less than one, which of the following may be
sources of repayment of the debt? (You may select more than one answer.)
b) Reduction in receivables
c) Reduction in inventory
Question 11: From the lender’s point of view, which of the following is the best
combination?
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FINANCIAL RATIOS — LEVERAGE 5-29
PROGRESS CHECK 5
(Continued)
Question 12: From the lender’s point of view, which of the following is the worst
combination?
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ANSWER KEY
Question 12: From the lender’s point of view, which of the following is the worst
combination?
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Unit 6
UNIT 6: FINANCIAL RATIOS — TURNOVER
INTRODUCTION
Liquidity ratios try to answer the question, “What is the degree of coverage of liquid assets
for short-term obligations?” Turnover ratios try to answer the question, “How long does it
take the firm to realize receivables or inventories, or to pay its trade suppliers?”
In this unit, we will see how turnover ratios complement liquidity ratios by informing
the analyst of the time it takes a company to convert trade receivables and inventory into
cash, or the amount of funds that has been provided by trade receivables. Correct reading of
the ratios, along with additional information about a company’s business, may also help the
analyst to evaluate the quality of current assets. This determination is important in judging
liquidity, since current ratio coverage of liquid assets over short-term obligations
presupposes timely liquidation of receivables and inventory.
Some turnover ratios may be calculated in two ways: either as a straight turnover or
converted to days. The commonly used turnover ratios include:
Other turnover ratios may also be calculated, including days cash and securities or days
accruals, but the ratios listed above are the most common.
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6-2 FINANCIAL RATIOS — TURNOVER
UNIT OBJECTIVES
n Calculate days inventory (amount of inventory on the balance sheet date relative
to the annual production)
The sales figure should represent the entire year to prevent distortion
and to allow comparison to prior annual figures. For interim
calculations, the sales figure should be annualized, taking into account
any seasonal factors in the sales.
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Net credit sales Notice that the correct figure for sales is net credit sales, not total
not itemized net sales, because receivables, by definition, are sales made on a
in income credit basis. Sales made on a cash basis do not generate accounts
statement receivable. Yet, the Citibank spreadsheet calculates on the basis of net
sales (as is the case with the spreadsheet of most banks). If this
is technically incorrect, why do banks calculate this way? The reason
is that the income statement does not tell us what percentage of sales
is on a credit basis and what percentage is on a cash basis.
Use Many companies that sell on credit terms do so for 100% of their
approximate sales. In these cases, net credit sales and total net sales are the same.
percentages If an analyst studies the financial statements of a company with
significant amounts of both credit and cash sales, he/she should find
out the approximate percentages and calculate an adjusted turnover.
Another point worth noting is the effect of value added taxes. If sales
taxes are included within the sales figure, then these must be netted
out as well.
Net out other Note, also, that we use trade receivables for this calculation. This
receivables means that other receivables, those not generated from normal trade
operations of the company, should be netted out to avoid distortion of
the numbers.
Examples Let’s look at the example of receivables turnover for two companies
in Table 6.1.
Company A Company B
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6-4 FINANCIAL RATIOS — TURNOVER
From these numbers, we can see that Company A turns over its trade
receivables four times per year while Company B turns over its trade
receivables twelve times per year. Therefore, Company B collects
much faster than Company A.
Days Receivable
Period of Taking the example in Table 6.1, a turnover of 4.0 means 90 days,
one year because 90 days is 1/4 of a year. A turnover of 12 times means 30
days, because 30 is 1/12 of a year. So days can be calculated by
dividing 360 by the turnover.
Period of less If we are calculating turnover for a period of less than one year, we
than one year substitute the appropriate number of days in the period for the 360.
For example, if the period is six months, we substitute 180 in the
formula.
In Table 6.2, you can see the calculation of days receivable for the
companies from Table 6.1.
Company A Company B
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FINANCIAL RATIOS — TURNOVER 6-5
The figure for days receivable represents the collection period for
each company.
Collection In studying the companies, the analyst should compare these numbers
period relative to the average credit terms granted by the company. If Company A in
to credit terms the example, grants credit terms of 90 days and Company B grants 30
days, then both are collecting well and probably have good quality
receivables on the balance sheet. However, if Company A grants terms
of 60 days, but is collecting
in 90 days, then we question the quality of the receivables —
apparently there are significant amounts of past due accounts within
the balance sheet.
Average Note that these calculations are based on year end numbers. Use
receivables of average numbers for the year would be more precise, and would
for the year provide the average collection period for the year. If we have monthly
balance sheets, we can obtain a more precise average receivables
figure during the year for this computation — but an analyst rarely has
the luxury of monthly figures.
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Summary
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FINANCIAL RATIOS — TURNOVER 6-7
You have now completed the section on “Receivables Turnover / Days Receivable.” Please
complete Progress Check 6.1 before continuing on to the next section, “Inventory Turnover
or Days Inventory.”
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FINANCIAL RATIOS — TURNOVER 6-9
Directions: Select the correct answers for the following questions. There is only one correct
answer unless otherwise stated in the question. Check your answers with the
Answer Key on the next page. If you answer any of the questions incorrectly,
return to the appropriate section of the text and review the material.
Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000
and net sales totaled $400,000. All sales are made on credit terms.
____ a) 8 times
____ b) 10 times
____ c) 12 times
____ d) 14 times
Question 3: The correct formula for calculating days receivable for one year numbers is:
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6-10 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 1: On December 31, 19X6, ABC Company's trade receivables totaled $50,000
and net sales totaled $400,000. All sales are made on credit terms.
c) 12 times
Question 3: The correct formula for calculating days receivable for one year numbers is:
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Question 4: Kappa Company’s annual sales are 240 million pesos, 75% of which are made
on credit terms of 60 days. The year end trade receivables are 30 million.
Calculate the days receivable.
Calculation:__________________
Days receivable:______________
Question 5: Gamma Company’s annual sales are 480 million pesos, half of which are on
credit terms of 90 days. Sales are made evenly during the year and there are
no problems with past due accounts. Calculate the year end balance sheet
figure for trade receivables.
Calculation:___________________
Trade receivables:______________
Question 6: Based on the data from Company A, complete the following questions.
Company A
Cash 2,600
Marketable Securities 1,500
Trade Receivables 8,200
Inventories 13,000
Current Assets 25,300
Current Liabilities 11,000
Net Credit Sales 72,000
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6-12 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 4: Kappa Company’s annual sales are 240 million pesos, 75% of which are made
on credit terms of 60 days. The year end trade receivables are 30 million.
Calculate the days receivable.
Days receivable: 60 i
Question 5: Gamma Company’s annual sales are 480 million pesos, half of which are on
credit terms of 90 days. Sales are made evenly during the year and there are
no problems with past due accounts. Calculate the year end balance sheet
figure for trade receivables.
Trade receivables: 60 i
Question 6: Based on the data from Company A, complete the following questions.
Company A
Cash 2,600
Marketable Securities 1,500
Trade Receivables 8,200
Inventories 13,000
Current Assets 25,300
Current Liabilities 11,000
Net Credit Sales 72,000
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Inventory Turnover
Company X Company Y
From these numbers, we can see that Company X turns over its
inventory twice as fast as Company Y.
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6-14 FINANCIAL RATIOS — TURNOVER
Days Inventory
However, if we’re dealing with a period of less than one year, then we
substitute the appropriate number of days in the period for the 360.
For example, for six month figures, we substitute 180 in the formula.
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Example In Table 6.4, we calculate the days inventory for the same two
companies that we saw in the inventory turnover example.
Company X Company Y
Length of time The figure for days inventory represents the amount of inventory
company can at the balance sheet cutoff date relative to annual production costs.
operate without This indicates approximately how many days the company can operate
production without additional production before closing its doors. For
a commercial company where the entire inventory is finished goods,
this approximate number may be close to reality — as long as there
are no major seasonal effects. For an industrial company, this is a very
rough estimate because inventory is composed of both finished goods
and raw materials.
Consider type Actually, for an industrial company, the type of inventory should
of inventory be considered in the calculation of days inventory because the cost
element is different. Finished goods are valued at cost of goods sold
(raw material, labor, and overhead), but raw materials are valued at
purchase cost (or market, whichever is lower). This means that if
inventory is composed mostly of finished goods, the traditional
calculation can be quite accurate. If the inventories are essentially raw
materials (RM), the following calculation may be more appropriate:
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6-16 FINANCIAL RATIOS — TURNOVER
Type of The type of company will determine the inventory an analyst should
company consider. A shoe producer may have different styles, sizes, and colors
of products in stock, besides considerable amounts of raw materials. It
is a working capital intensive business. Commercial companies also
are inventory intensive, by nature, so these types of companies will
tend to have greater amounts of inventory on their balance sheets. On
the other hand, transport companies, and other service companies such
as hotels, have little need for inventory and will, therefore, have lower
levels on their balance sheet.
Selling Selling methodology also has an impact. Does the firm sell on a
methodology specific contract basis, or does it sell from stock? The first case may
involve little need for finished goods, while the second will have
greatly increased needs.
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FINANCIAL RATIOS — TURNOVER 6-17
Reasons for Some clients say they prefer to maintain higher inventory levels “to
higher inventory protect themselves against inflation,” “to get volume discounts on
purchases,” or “to nail down a lower exchange rate.” All of these may be
true in specific cases, if the savings from lower prices at purchase
compensate for inventory carrying and financial costs. With the current
significantly reduced inflation levels and greater economic stability in
Latin America, these client comments are heard less and less.
Summary
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6-18 FINANCIAL RATIOS — TURNOVER
For periods of less than one year, the correct number of days is used
in place of 360.
In assessing the days inventory number, the analyst must consider the
following issues:
You have now completed the section on “Inventory Turnover or Days Inventory.” Please
complete Progress Check 6.2 before continuing on to the next section, “Payables Turnover
or Days Payable.”
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FINANCIAL RATIOS — TURNOVER 6-19
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000,
the inventory turnover is _____ times and the inventory turnover time is
_____ days.
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ANSWER KEY
Question 7: If the cost of goods sold equals $2,400,000 and inventories equal $600,000,
the inventory turnover is 4 times and the inventory turnover time is
90 days.
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Using the most precise formula, calculate the days inventory at the balance
sheet date.
____ a) 72 days
____ b) 60 days
____ c) 80 days
____ d) 90 days
Question 10: Which type of company will tend to have the greatest inventory needs as
a percentage of total assets?
____ a) Hotel
____ b) Plastics producer
____ c) Department store
____ d) Mail courier
Question 11: Indicate whether the following statements are (T) true or (F) false.
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ANSWER KEY
Using the most precise formula, calculate the days inventory at the balance
sheet date.
d) 90 days
Question 10: Which type of company will tend to have the greatest inventory needs as
a percentage of total assets?
c) Department store
Question 11: Indicate whether the following statements are (T) true or (F) false.
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Payables Turnover
Measured Payables turnover indicates the number of times that payables are rotated
against during the period. It is best measured against purchases, since purchases
purchases generate accounts payable.
The purchases figure should represent the entire year, or the ratio will
be distorted and not comparable to prior annual figures. For interim
calculations, the purchases figure should, therefore, be annualized,
taking into account any seasonal factors in purchasing.
Company E Company F
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Days Payable
Let’s calculate the days payable for the same two companies:
Company E Company F
Average The figure for days payable represents the average payment period
payment for the company. In studying the companies, the analyst would like to
period compare these numbers to the average credit terms received by the
company.
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Common Variation
Substitutes cost The reason is that the figure for purchases normally is not specified in
of goods sold the income statement, so we use the second best alternative as a
default. Notice that for a commercial firm this distinction is not
relevant. There is no processing of the goods and, therefore, the figure
for purchases is essentially the same as cost of goods sold.
For an industrial firm, there may be a significant difference. Let’s look
at the same two companies, but this time we will include a figure for
cost of goods sold.
Company E Company F
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Implicit error In the first case, the variance, or implicit error in calculating by
using CGS basis the CGS basis, is 33%, in the second case, it is 20%. The analyst,
therefore, must understand how the spreadsheet calculates and
recognize this implicit error when interpreting the spreadsheet
calculations. This applies to days payable for industrial companies or
for any other companies that have a significant amount of value added
to their products.
Seasonality
Example Theta Company sells clothing to the general public. All purchases
are on a credit basis, with average terms of 60 days. Total annual
purchases are 1,000, but purchases in November and December
together constitute 30% of this total.
In judging this number, the analyst can easily compare it to the credit
terms of 60 days and conclude that there are problems with payment
of receivables. Wrong conclusion!
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FINANCIAL RATIOS — TURNOVER 6-27
Recognize The higher the days payable, the better from a funds flow point of view.
reasons behind However, if the numbers for this ratio, adjusted for seasonality, are too
the numbers high, this may indicate delayed payments to suppliers, possibly due to
cash flow difficulties. This could indicate serious trouble in a very
short period of time. A very low number should also be analyzed to
determine why this usually cheaper source of funding is not being
maximized. Are suppliers cutting back on credit? If so, what is the
reason for this?
Shorthand The days payable number is often analyzed in tandem with days
funds flow receivable and days inventory for a shorthand funds flow analysis. This
analysis very generalized analysis may be used to estimate the working capital
requirements for a company. Remember, this is very generalized
because, all of these funds flows may be measured against a different
base (i.e. receivables vs. sales, inventory vs.
cgs, payables vs. purchases) so that each of the “days” has a
different value.
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+ Days receivable
+ Days inventory
- Days payable
= Operational working capital
Summary
Days payable is the average payment period for a company and may be
compared to credit terms to evaluate a company’s payment of
receivables.
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Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials
constitute 75% of cost of goods sold, and payables equal $1,600,000,
the more exact figure for payables turnover is _____ times and the
corresponding days payable is _____.
Question 13: The formula for calculating days payable for one year figures with the most
precision is:
Question 14: The formula for calculating days payable for one year figures used within the
Citibank spread sheet is:
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ANSWER KEY
Question 12: If an industrial firm's cost of goods sold is $9,600,000, raw materials
constitute 75% of cost of goods sold, and payables equal $1,600,000, the
more exact figure for payables turnover is 4.5 times and the corresponding
days payable is 80 .
Question 13: The formula for calculating days payable for one year figures with the most
precision is:
Question 14: The formula for calculating days payable for one year figures used within the
Citibank spreadsheet is:
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Question 15: Indicate whether the following statements are (T) true or (F) false.
____ a) Payables turnover indicates the number of times payables are rotated
during the period.
____ b) Company M has payables turnover of 10 times and Company N has
payables turnover of 6 times. Company M’s trade suppliers probably offer
more generous credit terms.
____ c) Payables turnover of 12 times is the same as 24 days receivable.
____ d) The figure for days payable represents the average payment period
for a company.
Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days
from its suppliers, but the year-end balance sheet indicates 108 days payable.
What are possible explanations of this situation, in whole or in part?
____ a) The high value added content of Beta’s production results in an implicit
error when calculating on a cgs basis.
____ b) Seasonal purchases at the end of the year distort the calculated ratio.
____ c) Beta Company has just increased its credit terms to buyers.
____ d) Beta Company pays late.
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ANSWER KEY
Question 15: Indicate whether the following statements are (T) true or (F) false.
Question 16: Beta Company, an industrial firm, receives average credit terms of 60 days
from its suppliers, but the year-end balance sheet indicates 108 days payable.
What are possible explanations of this situation, in whole or in part?
b) Seasonal purchases at the end of the year distort the calculated ratio.
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Spreadsheet It is best calculated against average total assets but, here again,
calculation spreadsheets usually make a trade-off by calculating against end-
of-period total assets. If there has been considerable growth in
assets during the year, or if the company’s business is very seasonal,
resulting in major swings in asset totals during the year, then the
analyst should obtain some additional numbers to enable calculating
average figures.
Company J Company K
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The higher, Generally, the higher the asset turnover the better — more sales are
the better achieved with a given amount of asset resources. Where the turnover
is higher, there is greater operational efficiency.
It should be noted that leased assets off the balance sheet will distort
the asset turnover ratio by reporting a higher turnover than a “real”
figure would indicate. Therefore, if significant amounts of such assets
are used by the company, the analyst should adjust the balance sheet by
including these assets and recalculating this ratio.
You have completed Unit Six: Financial Ratios — Turnover. Please answer the questions
in Progress Check 6.4 to check your understanding of the material before proceeding to
Unit Seven: Financial Ratios — Profitability.
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FINANCIAL RATIOS — TURNOVER 6-35
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 17: The sales / average total assets ratio measures the:
Question 18: Calculate the asset turnover ratio for Companies Q and R.
Company Q Company R
Sales 800 1200
Total Assets 600 1500
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6-36 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 17: The sales / average total assets ratio measures the:
Question 18: Calculate the asset turnover ratio for Companies Q and R.
Company Q Company R
Sales 800 1200
Total Assets 600 1500
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FINANCIAL RATIOS — TURNOVER 6-37
Question 19: Of the following types of companies, which would tend to have the
highest (H) and the lowest (L) asset turnover?
____ Hotel
____ Medium industry
____ Trading company
Question 20: Which of the following would tend to increase the sales / total assets ratio?
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6-38 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 19: Of the following types of companies, which would tend to have the highest
(H) and the lowest (L) asset turnover?
L Hotel
H Medium industry
Question 20: Which of the following would tend to increase the sales / total assets ratio?
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FINANCIAL RATIOS — TURNOVER 6-39
Question 21: Use the following data to calculate the information requested for Company C
and Company D.
Company C Company D
Cash 21,000 18,000
Marketable Securities 2,000 1,000
Trade Receivables 46,000 53,000
Inventories 71,000 78,000
Current Assets 140,000 150,000
Total Assets 300,000 400,000
Current Liabilities 84,000 82,000
Trade Payables 40,000 35,000
Net Sales 485,000 569,000
Cost of Goods Sold 462,000 540,000
Company C Company D
Current Ratio
Acid Test
Receivables Turnover (Times)
Average Collection Times (Days)
Inventory Turnover (Times)
Average Inventory Turnover Period (Days)
Payables Turnover (CGS Basis)
Days Payable
Sales to Assets Turnover
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6-40 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 21: Use the following data to calculate the information requested for Company C
and Company D.
Company C Company D
Cash 21,000 18,000
Marketable Securities 2,000 1,000
Trade Receivables 46,000 53,000
Inventories 71,000 78,000
Current Assets 140,000 150,000
Total Assets 300,000 400,000
Current Liabilities 84,000 82,000
Trade Payables 40,000 35,000
Net Sales 485,000 569,000
Cost of Goods Sold 462,000 540,000
Company C Company D
Current Ratio 1.67 1.83
Acid Test .82 .88
Receivables Turnover (Times) 10.5 10.7
Average Collection Times (Days) 34 34
Inventory Turnover (Times) 6.5 6.9
Average Inventory Turnover Period (Days) 55 52
Payables Turnover (CGS Basis) 11.6 15.4
Days Payable 31 23
Sales to Assets Turnover 1.6 1.4
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FINANCIAL RATIOS — TURNOVER 6-41
Question 22: Indicate whether the following statements are (T) true or (F) false.
____ b) The difference between the frequency with which inventory is converted
into cash, shown by Company C and Company D, is not very large.
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6-42 FINANCIAL RATIOS — TURNOVER
ANSWER KEY
Question 22: Indicate whether the following statements are (T) true or (F) false.
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Unit 7
UNIT 7: FINANCIAL RATIOS — PROFITABILITY
INTRODUCTION
Companies are in business for one purpose — to make profits. If a company accumulates
considerable losses year after year, it will not stay in business for long. Profits are the
driving force of growth and are the main source for repaying loans, making new
investments, and providing an adequate return to owners so they retain their interest
and financial backing.
Profits are important for another reason — they measure the relative success of a company
and can readily be compared to other companies and to the capital market. Therefore,
profits reflect (and profit ratios measure) the effectiveness and efficiency
of management. The common profitability ratios are:
n Return on Sales
n Return on Assets
n Return on Equity
UNIT OBJECTIVES
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7-2 FINANCIAL RATIOS — PROFITABILITY
PROFITABILITY RATIOS
Return on Sales
Dollar profit per The return on sales ratio (profit on sales) measures how many
$100 in sales dollars of profit are made for every $100 in net sales. The figure is
a percentage and is calculated as:
Net Income
Return on Sales = x 100
Net Sales
Company A Company B
We can see that Company A earned $20 for every $200 in sales,
a profit of 10%. Profits earned by Company B were higher in
monetary terms; but at 2.5% of net sales, they were proportionally
lower than those earned by Company A. Therefore, Company A
generates more income on each $1.00 in sales than Company B. This
is an indication that Company A generates profits more efficiently.
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FINANCIAL RATIOS — PROFITABILITY 7-3
Return on Assets
Relationship Return on assets is a good indicator of the productivity of the firm and
between profits of management's abilities and efficiency. The index measures the
and resources relationship between profits and total resources invested. It is a
invested percentage and is computed as:
Net Income
Return on Assets = x 100
Average Assets
Since asset values vary during the year, the best measure is based on an
average of beginning-of-year assets and end-of-year assets. Let's look
at an example and compare the ratios calculated two ways.
Average of The more accurate method is to calculate return on assets based on the
beginning and average of beginning-of-year and end-of-year figures.
ending assets
For 19X1, $ 150 / [($ 4,000 + $ 6,000) / 2] = 3.0%
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7-4 FINANCIAL RATIOS — PROFITABILITY
The higher, Return on assets is best measured against prior period results from the
the better same firm or against similar enterprises. The higher the result, the
better, since a good return on assets indicates efficient use of the
firm's resources.
Profits Return on equity ( ROE) measures the profits generated by each dollar
generated by accumulated in the business by stockholders. The figure is
each $1 a percentage and is computed as:
invested
Net Income
Return on Equity = x 100
Average Net Worth
If the ROE figure is very low in comparison to time deposit rates, the
owner is further ahead to liquidate the company's assets and deposit
the money in a bank. In these situations, the creditor should question
the owner's commitment to the firm, especially if the financial
situation deteriorates further.
Understand the In order to avoid some distortion in interpreting the figure, the
client’s situation practical situation of the client should be understood. For example,
in a family enterprise, the analyst should consider (depending
on the market) that profits may be underestimated for tax purposes. In
these situations, the ROE figure is negatively impacted, and
comparison to other potential investments will be less valid.
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FINANCIAL RATIOS — PROFITABILITY 7-5
Since the income was generated during the whole period, and
not just at the end, the average net worth should be used when
computing the figure. However, if prior period figures are not
available, ending period figures may be applied instead. For interim
figures, net income should be annualized. In seasonal situations,
this factor should be considered within the annualization to avoid
distortions in the net income figure.
Example Let's look at the difference between using only the ending balance
and an average of the beginning and ending balance.
19X0 19X1
Net income $ 20 $ 60
Stockholders’ equity $2,000 $2,400
* Since the beginning value is $ 2,000 and the ending value $ 2,400, we may
presume that the owners' investment for the year averaged $ 2,200.
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7-6 FINANCIAL RATIOS — PROFITABILITY
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FINANCIAL RATIOS — PROFITABILITY 7-7
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 2: Please indicate whether each item is (T) true or (F) false. Return on
assets is:
Question 3: Select all that apply. A high return on equity for a firm may indicate:
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7-8 FINANCIAL RATIOS — PROFITABILITY
ANSWER KEY
c) how many dollars of profit are made for every $100 of sales.
Question 2: Please indicate whether each item is (T) true or (F) false. Return on
assets is:
Question 3: Select all that apply. A high return on equity for a firm may indicate:
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FINANCIAL RATIOS — PROFITABILITY 7-9
Question 4: Let’s look at selected numbers from the financial statements of Companies S,
T, and U.
Company S Company T Company U
Net Sales 1,000 1,000 1,000
Average Assets 1,500 800 400
Average Net Worth 900 400 100
Net Income 200 120 40
Question 5: From the numbers in the previous question, answer each question by entering
the correct company.
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7-10 FINANCIAL RATIOS — PROFITABILITY
ANSWER KEY
Question 4: Let’s look at selected numbers from the financial statements of Companies S,
T, and U.
Company S Company T Company U
Net Sales 1,000 1,000 1,000
Average Assets 1,500 800 400
Average Net Worth 900 400 100
Net Income 200 120 40
Question 5: From the numbers in the previous question, answer each question by entering
the correct company.
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FINANCIAL RATIOS — PROFITABILITY 7-11
INTEGRATED ANALYSIS
Integrate Let’s consider some theories used to integrate several of the main
financial ratio concepts encountered in the units covering financial ratios. These
concepts ideas also will tie together the profitability ratios we have just
considered. They are taken from financial relationships known as
a DuPont Analysis.
Return on Assets
Asset
ROS Turnover ROA
Net Income X Net Sales = Net Income i
Net Sales Total Assets Total Assets
Operational ROS can be considered cost efficiency, while asset turnover can be
leverage considered a multiplier to achieve asset efficiency (which is ROA).
So, the higher the asset turnover, the greater the ROA. This is the
concept of operational leverage.
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7-12 FINANCIAL RATIOS — PROFITABILITY
Return on Equity
Asset
ROA Leverage ROE
Net Income X Total Assets = Net Income
Total Assets Net Worth Net Worth
Financial Here, again, we see that the beginning figure is multiplied by the next
leverage column (in this case leverage) to obtain the final column, in this case
ROE. By multiplying ROA to obtain a figure for ROE, we can clearly
see how greater debt levels actually “leverage” earnings. This is the
concept of financial leverage.
From this formula, we can appreciate that greater leverage will achieve
greater earnings. This is correct as long as ROS is not adversely
affected by greater interest expense. Remember your vantage point.
The borrower uses this as an excuse to operate with greater debt
levels. The lender is more interested in reducing risk. If the investor
leverages up by taking on greater debt to finance capital expansion,
this may yield greater financial returns, but leave the firm vulnerable
to an economic downturn and/or higher interest rates.
The credit risk increases.
Asset Asset
ROS Turnover ROA Leverage ROE i
Net Income X Net Sales = Net Income X Total Assets = Net Income
Net Sales Total Assets Total Assets
; Net Worth Net Worth
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FINANCIAL RATIOS — PROFITABILITY 7-13
Example Let’s apply these concepts to some numbers to see if we can obtain an
idea of what is appropriate in terms of ROS, ROA, and ROE for
different companies through the DuPont insights. Consider the
following numbers for Companies X, Y, and Z.
What insights can we get from these numbers using the DuPont
format? We have included the same numbers below. Remember,
the figure for asset leverage is 1.0 more than the standard debt / equity
leverage figure.
Net Income X Net Sales Net Income X Total Assets Net Income
Net Sales Total Assets Total Assets
; Net Worth Net Worth
Company X
Why does Company X have the same ROE as Y and Z despite having the
highest ROS by a wide margin? Because it has low multipliers — asset
turnover is low. Why is it low? The reason is probably due to the nature
of the company. It may be a heavy industry with heavy fixed asset needs
that operate as a brake on the ROE ratio. Leverage is also low (debt /
equity is 0.67), probably for the same reason.
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7-14 FINANCIAL RATIOS — PROFITABILITY
Company Y
Company Y’s multipliers are higher than X’s, but lower than Z’s. Why?
It is probably a different type of company. With these numbers, it looks
like a medium industry, with asset turnover just greater than 1.0 and
leverage about the same (note: debt / equity = 1.00).
Company Z
Company Z’s multipliers are very high, enabling an equal ROE despite
a very low margin. Why? It is probably a company with
low fixed asset needs and high liquidity of assets, permitting higher
leverage (equivalent debt / equity = 3.00). As such, there are probably
low barriers to entry in the business, which means it is probably a
highly competitive sector with low margins. It probably
is a wholesaler or trading company.
Lesson: Low margins can mean good profits overall if the asset and
leverage multipliers can be managed properly.
Conclusions
What is an We have been able to draw some conclusions from this analysis in
appropriate terms of what is appropriate for ROS. If a company, by nature, has low
ROS? multipliers, ROS must be high to achieve an acceptable ROE. As
multipliers increase, ROS may be reduced, as well, and still achieve an
acceptable ROE.
Changed 07/02/96
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FINANCIAL RATIOS — PROFITABILITY 7-15
Appropriate From this viewpoint we also can appreciate that ROE sets the tone for
ROE the other ratios. The appropriate figure for ROS depends on the
determined by multipliers. The appropriate figure for ROA depends on the leverage
capital markets multiplier. What is appropriate for ROE? Capital markets determine
this, not multipliers. An acceptable ROE will be similar for all
companies in the market (higher for riskier sectors), regardless of
the multipliers. In the final analysis, the ROE figure will determine
which company has the best earnings.
Summary
You have completed Unit Seven: Financial Ratios — Profitability. Please answer the
questions in Progress Check 7.2 to check your understanding of these concepts. Following
the Progress Check is a summary chart of the financial ratios we have presented in this
workbook. Use it as a review for the final unit, Applied Financial Analysis – Case Studies,
and also as a handy reference in the future.
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7-16 FINANCIAL RATIOS — PROFITABILITY
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FINANCIAL RATIOS — PROFITABILITY 7-17
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 7: Please indicate whether each item is (T) true or (F) false.
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7-18 FINANCIAL RATIOS — PROFITABILITY
ANSWER KEY
Question 7: Please indicate whether each item is (T) true or (F) false.
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FINANCIAL RATIOS — PROFITABILITY 7-19
Question 8: Which type of company, by nature, should have the highest normal figure for
ROS?
Question 9: Which of the following companies, by nature, should have the lowest normal
figure for ROS?
Question 10: Company R has the following ratios. What is its ROE?
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7-20 FINANCIAL RATIOS — PROFITABILITY
ANSWER KEY
Question 8: Which type of company, by nature, should have the highest normal figure for
ROS?
a) Heavy industry
Question 9: Which of the following companies, by nature, should have the lowest normal
figure for ROS?
d) Trading company
Question 10: Company R has the following ratios. What is its ROE?
SOLUTION:
Asset Asset
ROS × Turnover = ROA; × Leverage = ROE
10% 1.5 15% 2.5 37.5%
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FINANCIAL RATIOS — PROFITABILITY 7-21
The following chart is a summary of the financial ratios covered in the Financial Statement
Analysis Workbook. Please review the chart before continuing to Unit Eight: Applied
Financial Analysis — Case Studies. Also, use it as a convenient reference in the future.
LIQUIDITY
Current Assets The higher, the better
Current Current Liabilities
Cash + Near Cash Assets + Trade Receivables The higher, the better
Acid Test Current Liabilities
OPERATING
Average Trade Receivables x 360 The lower, the better,
Days Receivables Net Credit Sales generally
Average Inventories x 360 The lower, the better,
Days Inventory Cost of Goods Sold generally
Average Trade Payables x 360 The higher, the better,
Days Payables Total Purchases generally
Net Sales I The higher, the better,
Assets Turnover Average Total Assets generally
LEVERAGE
Total Indebtedness Total Liabilities I The lower, the better
Tangible Net Worth
COVERAGE
Interest Coverage GOCF I The higher, the better
Gross Interest Expense
GOCF I The higher, the better
Debt Service Ratio
Gross Int Exp + Current Portion LTD
PROFITABILITY
Net Income I x 100
Return on Sales The higher, the better
Net Sales
Net Income I x 100 The higher, the better
Return on Assets Average Total Assets
Net Income I x 100 The higher, the better
Return on Equity Average Net Worth
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Unit 8
UNIT 8: APPLIED FINANCIAL ANALYSIS — CASE STUDIES
INTRODUCTION
In earlier units, we looked at accounting issues, basic analysis concepts, and financial
statement analysis. In this unit, we will review this material and apply the analysis to case
studies, using a bank spreadsheet financial analysis model.
UNIT OBJECTIVES
n Discriminate the client numbers by making any adjustments necessary for the
financial analysis
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8-2 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
n Balance sheet
n Income statement
n Ratios
n Certain account reconciliations
n Funds flow analysis
n Supplementary page, if needed, for more detailed breakdowns of
certain accounts
Aside from the OD-104, there are other formats for specialized or
non-conventional analysis. For example, analysis of banks and other
financial institutions is done on a spreadsheet that is appropriate for
bank financial statements.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-3
The remainder of this unit includes two case studies. By reading them,
and working through the practice exercises which follow,
you will be able to employ the concepts you learned in Units One
through Seven. The first case study in this unit — Mindy Garment
Factory — focuses on analysis of the balance sheet, income
statement, and financial ratios. The second case — Tower Stores —
focuses on reconciliations and the op / non-op statement.
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8-4 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
Company Name:
Country:
Amounts in 1= mill, 2 = thous, 3 = actuals:
(Insert spreadsheet -- Balance Sheet)
Currency:
Local Curr enter 0, US$ enter 1:
Financials: Audited / Direct: Audited Audited Audited INTERIMS
Qualified / Unqualified: Unqualified Unqualified Unqualified 0
Annual Data Quarterly
Statements Purchasing Power Date: 1/0/00 1/0/00 1/0/00
Statement Date: 1/0/00 1/0/00 1/0/00
No. of Months in Period: 0 0 0
BALANCE SHEET
Line # ASSETS
1 Cash - - - -
2 Marketable Secs - - - -
3 Acct Receivables - - - -
4 Inventory - - - -
5 Other Receivables - non-operating - - - -
6 Other Current Assets - (operating) - - - -
7 Other Current Assets - (non-operating) - - - -
14 Total Assets - - - -
LIABILITIES
15 Short-Term Debt - - - -
16 Current maturities of LT debt - - - -
17 Accts Payables - suppliers - - - -
18 Interest Bearing Payables - - - -
19 Income Taxes Payables - - - -
20 Other current liabilities - (operating) - - - -
21 Other current liabilities - (non-operating) - - - -
28 Total Liabilities - - - -
29 Minority Interest - - - -
30 Preferred Stock - - - -
31 Common Stock - - - -
32 Capital Surplus - - - -
33 Reserves - - - -
34 Retained Earnings - - - -
35 Capital Revaluation - - - -
36 Other Capital Account - - - -
37 Total Net Worth - - - -
38 Total Liabilities + Min. Int. + N. Worth - - - -
39 ***Balance Check Line - - - -
40 Contingent Liabilities - - - -
41 Pledged Assets - - - -
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-5
Pesos Thousands
42 Net Sales - - - -
43 Cost of Goods Sold (exclude Depreciation) - - - -
44 Selling & Admin Expenses (exclude Depreciation) - - - -
45 Operating Profit Bef Non-Cash Charges - - - -
48 Interest Income - - - -
49 Gross Interest Expense - - - -
50 Inflation income / (loss) - - - -
51 FX income / (loss) - - - -
52 Integral financing income / (loss) - - - -
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-7
Pesos Thousands
84 Operating Profit - - -
85 Depreciation & Amortization - - -
86 Other non-cash charges (Enter in section below) - - -
87 Gross Operating Cash Flow (GOCF or FFO) - - -
88 Changes in receivables - - -
89 Change in inventories - - -
90 Change in other current op.assets - - -
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-9
CASE STUDY:
MINDY GARMENT FACTORY
Introduction
The Mindy Garment Factory case involves an industrial company that requests a short-term
loan from a commercial bank to cover short-term operating needs. It is a new loan request
that must be analyzed by the bank's credit staff.
After reading the case study, you will be asked to perform a financial analysis of the
company as a practice exercise. The first step in the exercise is to examine the financial
statements submitted by the client, taking into consideration any additional verbal
information. Then, make any necessary adjustments to the client's numbers before including
them within the spreadsheet model. These adjustments, if any, pertain to the proper
presentation of the financial statements and those adjustments that are necessary for
calculating ratios. To do this, you must draw on basic accounting definitions and concepts
covered in Units One through Seven.
Once the adjustments have been made, you should compute the vertical analysis and
financial ratios included in the spreadsheet. To do this, you will draw on knowledge of
ratios and inter-account relationships covered in Units Four through Seven.
When the numbers have been laid out and the ratios computed, you will interpret the figures
to formulate financial conclusions and answer certain questions.
Background
Yesterday, January 20, 19X4, the financial analyst of the Friendly Bank received the
financial statements of the Mindy Garment Factory for the fiscal years ending September
30, 19X1, 19X2, and 19X3. The numbers submitted by the client are attached. The manager
of the bank has asked his trusted analyst to immediately perform the financial analysis,
since the credit request is to be considered in today's afternoon session of the credit
committee.
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The company, which is not yet a client of the bank, requested a loan for Pesos 300,000
(exchange rate = Pesos 2/US$) for 180 days. The analyst has heard of the company, but has
never been directly involved with them in business transactions. The reason for the
expedited treatment of this credit is that the factory's owners are friendly with one of the
bank's directors.
The company has been established in the market for many years. It manufactures general
clothing (men's, women's, and children's) for the domestic market (growth rate of about 5%
annually), aimed at the middle and upper middle classes. The Mindy Garment Factory
principally has dealt with the Uptown Bank and with a specialized public sector bank for
long-term financing. It is owned by a respected and socially prominent local family that has
a reputation for being very conservative and traditional in its business dealings.
Upon examining the financial statements, the analyst noted that the external auditor, the
firm of Siego, Zordo, & Mutho, was unfamiliar to him. The analyst had questions about
some of the numbers and called the general manager of Mindy for some clarifications. The
general manager has been with the company for fourteen years and was promoted to his
present position three years ago. Concerning the purpose of the loan, he said it was "for
working capital purposes."
With respect to sales, he indicated that “Sales are growing — following the same trends as
last year” and that “Our policy is to raise prices along with inflation,” now estimated at 15%
per year by the analyst. “We've never had problems with raising our prices due to the high
quality of our brand names and our entrenched market position,” said the manager. “We sell
85% of our production at 90 day terms to strong distributors. The other 15% is sold on a
cash basis through our own store, which is well located in the downtown shopping district.
The July - August - September quarter constitutes about 25% of annual sales and
production.”
The analyst also asked why inventories were higher and payables lower in the past year. The
general manager said that, in the case of inventories, “We wish to increase our stocks as a
hedge on inflation.” Regarding payables, he said that “Our policy is to buy some raw
materials on a cash basis to take advantage of discounts offered by some suppliers.”
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-11
Credit References
Before writing up his analysis, the analyst called an acquaintance at the Uptown Bank—
a friend since university years. The Uptown banker indicated that the Mindy Factory had
been a client of Uptown for eight years. The present owners were the second generation of
the family to direct the company; they took over three years ago and installed the present
general manager.
The banker mentioned that, when the company was taken over with long-term notes by the
present generation of owners, a certain amount of goodwill was put on the company's
books. Also, about six months ago, the Mindy Factory sold an old warehouse for Pesos
210,000. Terms of the sale were three years, including 18 months grace.
The Uptown Bank, because of traditional relationships, mainly dealt with the owners rather
than the management; obligations were paid in a satisfactory manner, although rollovers
(renewals) were frequent on the short-term loan. Six months ago, Uptown Bank approved a
new credit facility, with full recourse to Mindy, of Pesos 400,000 for the discount of
receivables.
(A “discount facility” is one where the bank "buys" certain of the customer's trade
receivables at a specified price, for example, at a 10% discount. This means that the
customer receives $90 for every $100 of receivables. The bank collects the receivables
when they are due for payment of the amount advanced to the customer, plus interest.
Structuring with “full recourse” to Mindy means that Mindy guarantees payment of the
transaction in case the trade receivables are not paid when they are due.)
The credit facility was fully taken down almost immediately, and outstandings have not
changed since then. The Uptown Bank also has financed equipment purchases for Mindy
over the years, generally with good results. Uptown is now near its legal lending limit with
Mindy.
Financial Statements
The financial statements presented by the general manager of the Mindy Company follow.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-15
EXERCISE 8.1
Directions: You are the financial analyst for Friendly Bank and you have been asked to
perform the financial analysis of the Mindy Garment Factory. This includes:
n Spreading the numbers onto the bank's own financial analysis form
There are four parts to the exercise. Upon completion of each part, check your answers with
the Answer Keys which follow.
PART I
Refer to the client's financial statements and complete the Friendly Bank Financial Analysis
Spreadsheet Model that appears on the next two pages. Check your spreadsheet with the
suggestions for analysis and the spreadsheet solution that follow.
Step 1: For purposes of analysis, make any necessary adjustments to the client's financial
statements — either to achieve conformity to accounting conventions or for
purposes of financial analysis. There are three adjustments to be made; they
pertain to the correct levels for trade receivables, other current assets, and
tangible net worth.
Step 2: Spread the numbers and calculate the percentages. Enter the figures, including
the adjusted figures, onto the partial spreadsheet format on the following two
pages. Ignore adjustments to the numbers for inflation.
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BALANCE SHEET
Line # ASSETS (to be supplied)
1 Cash - - - -
2 Marketable Secs - - - -
3 Acct Receivables - - - -
4 Inventory - - - -
5 Other Receivables - non-operating - - - -
6 Other Current Assets - (operating) - - - -
7 Other Current Assets - (non-operating) - - - -
14 Total Assets - - - -
LIABILITIES
15 Short-Term Debt - - - -
16 Current maturities of LT debt - - - -
17 Accts Payables - suppliers - - - -
18 Interest Bearing Payables - - - -
19 Income Taxes Payables - - - -
20 Other current liabilities - (operating) - - - -
21 Other current liabilities - (non-operating) - - - -
28 Total Liabilities - - - -
29 Minority Interest - - - -
30 Preferred Stock - - - -
31 Common Stock - - - -
32 Capital Surplus - - - -
33 Reserves - - - -
34 Retained Earnings - - - -
35 Capital Revaluation - - - -
36 Other Capital Account - - - -
37 Total Net Worth - - - -
38 Total Liabilities + Min. Int. + N. Worth - - - -
39 ***Balance Check Line - - - -
40 Contingent Liabilities - - - -
41 Pledged Assets - - - -
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-17
Pesos Thousands
42 Net Sales - - - -
43 Cost of Goods Sold (exclude Depreciation) - - - -
44 Selling & Admin Expenses (exclude Depreciation) - - - -
45 Operating Profit Bef Non-Cash Charges - - - -
48 Interest Income - - - -
49 Gross Interest Expense - - - -
50 Inflation income / (loss) - - - -
51 FX income / (loss) - - - -
52 Integral financing income / (loss) - - - -
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ANSWER KEY
PART I
Step 1: For purposes of analysis, make any necessary adjustments to the client's
financial statements — either to achieve conformity to accounting
conventions or for purposes of financial analysis. There are three adjustments
to be made which pertain to the correct levels for trade receivables, other
current assets, and tangible net worth.
The first task of financial analysis is to look at the numbers submitted by the client and
to make any necessary adjustments for purposes of analysis. This first step is important
to avoid computing inappropriate figures and indices, and to avoid making erroneous
conclusions based on incorrect ratios and data. The Mindy case offers three instances
where adjustments should be made to the statements submitted.
First Adjustment
The first adjustment — the most significant of the three — refers to the level of
receivables in the third year, which seems to have declined considerably over levels of
the previous two years. This "reduction" in 19X3 could lead the analyst to conclude that
efforts to collect overdue receivables have met with some success in the last year.
However, for purposes of financial analysis, we should add back to receivables the 400
of the receivables discount line opened and taken down about six months ago, prior to
the balance sheet cutoff date. This is because the company is still liable for these
receivables. Management has probably taken its best receivables to the Uptown Bank and
discounted them to get these assets off its balance sheet. This strategy "improves" the
receivables situation, but the overall situation really is the same or worse since the
receivables left on the balance sheet are probably of inferior average quality.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-19
If we increase the asset receivables by 400, then we must also increase the liability side
of the balance sheet. The liability adjustment should be to short-term bank debt, as if
Uptown had made a straight loan instead of booking the facility as a discount line.
These adjustments will have a major impact on the computation of days receivable (see
below), and also on current ratio and leverage.
Second Adjustment
The second adjustment pertains to the sale of the warehouse, for Pesos 210, that
occurred six months ago, prior to the balance sheet cutoff date. This should be listed on
the balance sheet as non-current since terms of the sale included 18 months grace. This
means that no money will be received until 18 months from the time of sale.
Apparently, the sale amount has been included within other current assets, given the size
of the increase in this account for 9/30/X3. This is inappropriate and raises doubts about
the quality of the external auditor. The 9/30/X3 balance sheet should be adjusted to list
this asset as long-term receivables on the non-current asset section. This will have an
adverse impact on the current ratio for the year 19X3.
Third Adjustment
The third adjustment relates to the goodwill on Mindy’s books. This asset is an
intangible and should be reduced from the owners’ equity section in each of the three
years to compute the “tangible net worth.” This is because an intangible that is not
readily salable should not be included as part of the capital “cushion” for creditors.
Also, the item has been inappropriately booked. Goodwill resulting from the sale
of the company for more than book value should be registered on the books of the
acquiring company, not the company acquired. Leverage will then be adversely
impacted.
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LIABILITIES
15 Short-Term Debt 625.2 928.8 1,817.0 -
16 Current maturities of LT debt - - - -
17 Accts Payables - suppliers 548.6 689.1 461.5 -
18 Interest Bearing Payables - - - -
19 Income Taxes Payables - - - -
20 Other current liabilities - (operating) 76.6 88.2 85.0 -
21 Other current liabilities - (non-operating) - - - -
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Pesos Thousands
42 Net Sales 3,501.5 3,934.0 4,358.9 -
43 Cost of Goods Sold (exclude Depreciation) 2,667.0 3,059.0 3,438.8 -
44 Selling & Admin Expenses (exclude Depreciation) 395.6 435.5 492.4 -
45 Operating Profit Bef Non-Cash Charges 438.9 439.5 427.7 -
48 Interest Income - - - -
49 Gross Interest Expense 116.4 151.1 279.2 -
50 Inflation income / (loss) - - - -
51 FX income / (loss) - - - -
52 Integral financing income / (loss) 248.7 212.7 57.7 -
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-23
EXERCISE 8.1
PART II
Based on the numbers from the preceding pages, compute the financial ratios for
19X1, 19X2, and 19X3. Do not calculate ratios for the blacked out boxes. Note that to
compute the days receivable number, you should remember that not all sales are made
on a credit basis.
RATIO ANALYSIS Annual Data Quarter
Statement Date:
No. of Months in Period:
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8-24 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Remember: Funds from Operations (FFO) is the same as Gross Operating Cash Flow (GOCF).
* Calculated: Dividends / Net Income
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EXERCISE 8.1
PART III
Interpret the results, focusing first on the income statement and then on the balance
sheet. In so doing, consider the percentage to sales as well as the ratios. Compare your
answers with the explanations on the following pages.
INCOME STATEMENT
Question 1: How do sales increases compare to inflation? What does this mean?
Question 2: Based on the numbers in the case, what do you think Mindy's pricing
policy situation might be?
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BALANCE SHEET
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-27
Question 7: What is the situation with fixed assets? What does it mean?
n Focus on accumulated depreciation.
Question 9: What can be said about the relationship between retained earnings and
capital of the firm?
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8-28 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART III
Income Statement
There is an obvious deterioration in the expense-to-sales relationships; each
year is producing less income on greater revenues. Several things, or more likely a
combination of several factors, could account for this.
Question 1: How do sales increases compare to inflation? What does this mean?
First of all, sales increases are lagging behind inflation despite the general
manager's assertion that price hikes are consistent with inflation. If what he
said is true, Mindy is selling less volume than in prior years. The company is,
therefore, losing market share since price increases account for the
monetary increases in sales. If this is not true, it indicates that the manager
has not been truthful or has insufficient control or understanding of his own
company.
In his favor, however, there could be some lag effect with rising prices and
inflation. On the other hand, if these can be passed on easily to the
company's buyers, as the manager asserts, then it should be factored into
pricing policies. Apparently, this has not been done.
Question 2: Based on the numbers in the case, what do you think Mindy's pricing policy
situation might be?
All of this could mean that pricing policies within Mindy are inadequate. Either
they have insufficient control of the company by not factoring all costs into
their price, or they have inadequate management information systems.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-29
This could also indicate a highly competitive position within the industry that
does not permit passing off the higher cost. However, this would contradict
what the manager has said about being able to pass off increased costs
because of their strong brand names and entrenched market position.
Eroding margins could indicate less efficiency than the competition, but it is
difficult to know this until we compare industry averages. Eroding margins,
together with the breakdown on net fixed assets, could indicate increasing
maintenance costs on aging machinery and equipment (the plant apparently
is very old, given the high accumulated depreciation in relation to the booked
fixed assets) and a competitive atmosphere that won't permit passing off
increased costs to the consumer.
Balance Sheet
The balance sheet reflects persistent deterioration, although it is not as obvious as on
the income statement. This deterioration is more pronounced after making the
adjustments in Part I of this exercise. The adjustments accentuate the decline in balance
sheet strength.
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8-30 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
Note, also, that the deviation from credit terms cannot be explained by
seasonality, since the July to September quarter comprises 25% of total
sales and production. In other words, the figures for the quarter should reflect
average numbers for the year.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-31
Question 7: What is the situation with fixed assets? What does it mean?
Accounts payable show a disturbing trend (74, 81, and 48 days) from the
cash flow perspective. We don't know what credit terms to the company are;
but, at a time when current asset funding needs are increasing, this usually
cheaper source of funds should certainly not be decreasing. The general
manager says he's buying for cash to get discounts, but this sounds
improbable. More likely, some suppliers are either declining to sell on credit or
cutting back on credit terms.
Question 9: What can be said about the relationship between retained earnings and capital
of the firm?
On the equity side, it should be noted that capital is quite low in comparison
to retained earnings. This could be a risk since retained earnings can more
easily be taken out as dividends. Since the dividend policy has been
reasonably generous in the past, this could indicate a willingness to take out
more.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-33
EXERCISE 8.1
PART IV
Question 1: Are the following conclusions about Mindy's present financial situation
probably (T) true or (F) false?
Question 2: Select three reasons why the Mindy cash generation capacity is highly
suspect.
Question 3: The manager's stated purpose for requesting a loan is to increase “working
capital.” The more precise purpose of the loan probably is to:
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Question 4: Select three "clues" that indicate why the loan should not be granted.
Question 5: What lessons can be learned from this exercise? Check the statements
that apply.
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ANSWER KEY
PART IV
Question 1: Are the following conclusions about Mindy's present financial situation
probably (T) true or (F) false?
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Question 2: Select three reasons why the Mindy cash generation capacity is highly
suspect.
Question 3: The manager's stated purpose for requesting a loan is to increase "working
capital." The more precise purpose of the loan probably is to:
c) pay creditors.
Question 4: Select three “clues” that indicate why the loan should not be granted.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-37
The analyst can also assume that if the manager is not entirely forthright with
information before he receives the loan, there probably will be little cooperation
(should the loan be given) if there are problems with the credit. And, it is likely
that there will be immediate problems with the credit if the loan is made.
The timing of the loan request should also be noted since this business is
usually quite seasonal. January should be their best month for collecting from
their distributors after the Christmas sales. Requesting a loan now, in
January, is out of synchronization with their own business cycle.
The analyst's verdict, therefore, should be to deny the credit. Mindy is not yet
a client, and is not a desirable one either.
Question 5: What lessons can be learned from this exercise? Check the statements that
apply.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-39
CASE STUDY:
THE TOWER STORES
Introduction
In the Mindy case, you were introduced to the financial analysis spreadsheet model. You
looked at a customer's financial statements, made the necessary adjustments, included these
numbers within the model, and computed the ratios. This was done to perform a financial
analysis of the firm's historical figures and to decide whether or not a loan request should
be granted.
This case, Tower Stores, Inc., involves a commercial enterprise where the management
proposes a new sales strategy to promote greater growth and profits. The company requests
its bank's backing through an increase in short-term credit facilities. You, as the bank's
financial analyst, must measure the proposed strategies in light of historical trends to
project some key numbers. You will determine if the request should be accepted and,
if so, under what terms.
In this exercise, you will utilize the spreadsheet model not only to measure and analyze past
performance, but to project numbers into the future. Projections enable you to measure
anticipated cash generation and financial strength. In preparing these projections, you will
work with other sections of the spreadsheet that have not yet been covered.
The projections will be based on past trends and proposed new strategies. In building them,
you will draw on key financial concepts learned in Unit Two and on account relationships
encountered in the financial ratios of Units Four through Seven. By understanding these
relationships and the formulas for computing certain ratios, you
will be able to project numbers based on key assumptions.
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In preparing these projections, you must first analyze the customer's basis for his/her
projected figures to determine the feasibility of proposed financial strategies. In reaching
this determination, you, the analyst, will prepare your own projections based on your own
more pessimistic assumptions in an attempt to measure the sensitivity of the figures. This,
then, will depict an alternate, more conservative picture of what might happen if the
customer's financial strategies cannot be achieved and what this might mean in terms of
cash flow and potential additional cash needs. With this information, you will be better
prepared to reach conclusions and frame recommendations.
NOTE: Comparison of the customer's projected numbers with the bank's more
conservative projected numbers is an important step in the credit process.
Before beginning the Tower case, let's review the format of the spreadsheet model. You
will find it on the four pages following this section.
The form begins with the balance sheet on the first page, then an income statement and
certain reconciliations on the second page, the cash generation statement, and finally, a
page with ratios. We have already worked with some of these parts, so let's discuss the
other parts.
Reconciliations
There are two reconciliations: fixed assets and net worth. We will focus on these key
accounts and "squeeze out" any items that should be considered later for calculating cash
flows. Also, by focusing on these reconciliations, you will understand what is happening on
the balance sheet with these important accounts.
The fixed asset reconciliation begins with the opening net fixed assets for the period
which are the net fixed assets from the prior balance sheet. If the prior balance sheet is
not available, this computation cannot be made.
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After noting the opening net fixed assets, we subtract depreciation for the period.
Depreciation is the same figure that appears on the income statement. The subtotal is
then compared to the balance sheet net fixed assets. If the balance sheet number is
greater (as it usually is), it means that some fixed assets were acquired (or revalued)
during the period. The difference between the subtotal and the balance sheet net fixed
asset figure constitutes the capital expenditures for property, plant, and equipment
made during the period. Let's look at an example.
In this example, the ending fixed assets are less than opening fixed assets, even though
there was an increase in these assets during the period. If no other fixed assets had been
bought or sold during the year, the ending fixed assets would be 2,500, which is less
than the opening fixed assets by the factor of depreciation (500).
If the subtotal was greater than ending fixed assets, it would mean that some fixed
assets had been sold, or otherwise disposed of, during the period and had not been
replaced. The net effect would be a reduction of the balance sheet net fixed asset
account by an amount that is greater than depreciation.
The above example is a simplification of the concepts involved. The new Citibank
spreadsheet section for fixed asset reconciliation (below) covers the additional
concepts of inflation adjustments, revaluation, and type of capital expenditure.
It is important to consider these concepts.
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8-42 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
The inflation adjustment is for monetary correction of fixed assets. This is one of many
such adjustments within a monetary correction scheme.
As for revaluation, note that the previous simple calculation finds amounts of capital
expenditures by difference. In reality the amount of capital expenditures often
includes increases due to revaluation of fixed assets. These should be netted out, as in
the new spreadsheet, because these are accounting entries and do not reflect actual
acquisitions or cash movements.
The concept here is similar to that of the fixed asset reconciliation. The analysis begins
with the opening net worth figure, which is the same as the ending net worth of the
prior period. Again, this does not appear on the balance sheet, but must be sourced
from the prior period’s balance sheet. If the prior figure is not available, the
computation cannot be made.
The net income (or loss, expressed as negative income) for the period is added to the
opening figure. The subtotal indicates what the ending net worth figure would be if no
other adjustments were made. If the ending figure is greater than the opening figure
plus net income, it means that capital was injected into the company during
the period, or that net worth was increased in some other way, in the amount of the
difference. If the ending figure is less than the opening figure plus net income, it means
that capital was taken out or reduced. A reduction usually indicates payment of
dividends, but there may be other reasons such as a write off of certain assets.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-43
In this example, ending net worth is less than opening net worth plus net income, which
means that there was a reduction of capital. We can assume that this was due to
dividends, but the reason for the difference should be confirmed with the customer.
It should be noted that these reconciliations are accounting exercises — we are dealing
with arithmetical differences and not with theoretical possibilities. If the numbers
signal a difference, these amounts must be considered for cash flow purposes
regardless of the reason for the difference.
The new Citibank spreadsheet is now more sophisticated in this area, including lines for
inflation adjustments from monetary correction and balance sheet adjustments in the
case of foreign currency long-term debt devaluations.
This page of the Citibank spreadsheet directly focuses on the sources and uses of funds
concepts presented in Unit Two. The cash flow breaks down both sources into operational
and non-operational funds flows. By separating the flows into these distinct categories,
conclusions may be drawn about where funds have been used and about the sources for
these resource allocations.
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You will see an example of this in the case which follows. Notice that the customer’s
financial statements have already been spread using this format.
Tower Stores owns and manages several small department stores that sell clothing, shoes,
cosmetics, toys, televisions, other consumer electronics goods, and small kitchen and
household appliances. There are six stores, all well located throughout the country in
prestigious shopping centers or districts. The firm has earned an established and respected
market image by selling high quality products and by maintaining a reputation for
administrative integrity.
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The firm has been conservatively managed with a deliberate, but steady growth in operations
over the years. Several months ago, Teddy Tower, grandson of the founder, became general
manager of the company. He has worked in the family enterprise for four years since
graduating from a reputable business school in the USA where he specialized in marketing.
During his time in the company, he has gained experience in most of the major departments
of the firm, including the purchases, sales, finance, and administrative departments.
New Directions
Teddy believes the firm has been managed too conservatively over the years, resulting in
slim profitability. He thinks that the firm can achieve faster growth and greater
profitability with more aggressive sales policies involving increased credit terms from
present levels of about 25% (present maximum: 60 days) for the firm's select clientele.
Teddy also feels that trendier products could increase margins on the income statement
and accelerate inventory turnover. Teddy's idea is to cash in on the increasing purchasing
power of the growing middle class of Casablanca.
On the balance sheet, these changes would mean increased funding needs since
considerable increases in accounts receivable could be anticipated as a result of these
policies. This growth in receivables would result from the dual effect of the more
accelerated sales growth and the greater proportion of credit sales.
Teddy proposes to cover the anticipated increased funding needs from three sources:
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8-46 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
The financial statements for Towers Stores, Inc., have been spread and are attached.
Based on his own analysis of the company's situation and his assessment of the market,
Teddy Tower has just set goals for the year 19X4, which has just begun. Specifically, his
19X4 financial objectives for Tower Stores are to:
Commerce Bank is the principal bank for Tower Stores and currently offers them a credit
facility for short-term borrowings of Ps. 5,000,000 ( US$ 625,000), with an average usage
factor of about 80%. Teddy Tower has requested that the bank increase this line of credit to
Ps. 8,000,000 to support the company's anticipated increase in working capital needs. The
existing facility is offered without tangible collateral, but with personal guarantees
of key shareholders.
Tower Stores is a prime customer of Commerce Bank. The company provides strong
account earnings through intensive use of the short-term facility and the significant
volumes of trade and current account operations that are channeled through the bank.
Although he did not anticipate consistent use of more than Ps. 5,000,000 of this line (the
rest of the short-term needs would be supplied by other banks), Teddy requested the full
amount to cover seasonal needs and to act as insurance in case the working capital needs
turned out to be heavier than expected.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-47
BALANCE SHEET
Line # ASSETS
1 Cash 822 837 1,158
2 Marketable Secs - - -
3 Acct Receivables 1,512 2,627 2,255
4 Inventory 12,984 14,958 17,241
5 Other Receivables - non-operating - -
6 Other Current Assets - (operating) 262 505 347
7 Other Current Assets - (non-operating) 327 301 362
LIABILITIES
15 Short-Term Debt 2,151 3,957 5,240 -
16 Current maturities of LT debt 880 880 880
17 Accts Payables - suppliers 2,827 3,696 3,909
18 Interest Bearing Payables - - -
19 Income Taxes Payables 320 337 446
20 Other current liabilities - (operating) 612 688 767
21 Other current liabilities - (non-operating) - - -
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Pesos Thousands
42 Net Sales 56,420 68,432 78,690
43 Cost of Goods Sold (exclude Depreciation) 36,678 45,218 51,439
44 Selling & Admin Expenses (exclude Depreciation) 15,634 19,650 21,919
45 Operating Profit Bef Non-Cash Charges 4,108 3,564 5,332
48 Interest Income - - -
49 Gross Interest Expense 460 844 1,146
50 Inflation income / (loss) - - -
51 FX income / (loss) - - -
52 Integral financing income / (loss) 2,804 1,808 3,204
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Pesos Thousands
84 Operating Profit 2,652 4,350
85 Depreciation & Amortization 912 982
86 Other non-cash charges (Enter in section below) 0 0
87 Gross Operating Cash Flow (GOCF or FFO) 3,564 5,332
88 Changes in receivables 1,115 (372)
89 Change in inventories 1,974 2,283
90 Change in other current op.assets 243 (158)
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-51
EXERCISE 8.2
Directions: You are the new financial analyst for Commerce Bank. Your boss has asked
you to analyze Tower's financial statements and give an opinion about the
company's historical financial soundness. You are also to determine the
company's anticipated funds needs with their assumptions and with your own
adjusted numbers to test the sensitivity of the projections. Then, your boss
would like you to make conclusions about the overall financial analysis and
anticipated financial directions.
There are three parts to this exercise. Upon completion of each part, check
your answers with the Answer Key which follows the exercise.
PART I
Based on your knowledge of the Tower Stores financial statements, answer these questions
about the historical financial numbers included in the spreadsheet format.
Question 1: What does the vertical analysis indicate on the income statement?
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8-52 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
EXERCISE 8.2
(Continued)
b) Considering the type of enterprise, what do leverage ratios indicate about the
relative amount of capitalization?
b) What have been the non-operating cash needs, and how have these been
financed?
Question 5: How can financial performance be improved? What should Tower focus on
for improvement?
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-53
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8-54 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART I
Based on your knowledge of the Tower Stores financial statements, answer these questions
about the historical financial numbers included in the spreadsheet format.
Question 1: What does the vertical analysis indicate on the income statement?
d) On the balance sheet, the vertical analysis indicates stability with no major
swings in account composition.
e) Typically, for a commercial firm, current assets predominate over fixed and other
non-current assets. This situation has been accelerated in the past two years.
f) The composition of fewer liabilities than capital indicates a strong solvency, with
a leverage figure of less than 1.00. We will discuss this further in the next answer
about ratios.
g) On the asset side, there has been a great deal of stability — with a slight build
up in inventory and a relative reduction in net fixed assets in 19X3. On the liability
side, the most notable swing has been a relative build up in short-term bank debt
as long-term debt has been paid down.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-55
In summary, other than reflecting a great deal of stability within the company,
the vertical analysis tells us relatively little without a further basis for
comparison. However, the demonstrated stability is a useful observation when
considered within the rest of the analysis. We can anticipate that, with the
proposed changes, there is risk that this stability could be compromised in
the future.
a) The ratios seem to indicate a historically strong liquidity and solvency position for the
company, although liquidity has been decreasing. The decreased liquidity apparently
is due to improved inventory turnover and to increased levels of short-term bank
debt. The receivables turnover figures appear to be well within established credit
terms and receivables are placed with an established clientele. The principal current
assets of receivables and inventory, therefore, appear to support the liquidity
situation with realizable assets.
b) Leverage is quite strong at less than 1.00. This ratio indicates that Tower is not a
great credit risk since the creditors are amply covered by the firm's assets. This is
especially true when you consider that Tower Stores is a commercial enterprise. Due
to the liquidity of its assets, this type of firm normally reflects a higher range
of debt to equity than industrial enterprises.
a) The major funds needs in 19X2 were accounts receivable (34% of total operating
needs) and inventory (59%), together totaling over three million pesos in funds needs
for the year. In 19X3, the inventory increase was virtually all of the operating needs
for the year.
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8-56 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
b) Non-operating needs almost exclusively were for capital expenditures and reduction
of long-term bank debt. These were funded by short-term bank debt in 19X2, and by
net operating generation plus short-term bank debt in 19X3. While funding capital
expenditures with short-term debt is not advisable, the amounts are small (3% of total
assets in 19X2 and 5% in 19X3) and in the last year leverage was reduced.
a) Given that both liquidity and solvency of the firm appear to be strong, this question
now revolves around the question of profitability.
b) On a comparative basis from year to year, the return on sales (ROS) percentage
improved in year 19X3 (2.4%) after a decrease in 19X2 (1.6%). However, an outside
reference is needed in order to gauge the validity of the present figure. To determine
the adequacy of financial performance, you must focus on return on equity instead of
return on sales.
c) The return on equity (ROE) figure should be compared to outside references, such
as alternative investments in the marketplace and the inflation figure. It appears
that Tower's ROE figure of 13.3% for 19X3 is about even with inflation, so from an
investment point of view, the figure is approaching an adequate range, but cannot
be considered strong.
Because the ROE figure is at the lower range of acceptability, we may conclude
that profitability performance has been acceptable, but could be better. At least
profits have been highly stable. Teddy Tower may be correct in believing that the
firm has been managed too conservatively, especially when considering that the
12/31/X3 leverage (debt / equity) figure of 0.81 is low for a commercial enterprise.
If the ROS figure could be improved, and the firm leveraged up somewhat, the
ROE could be boosted significantly.
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-57
Question 5: How can financial performance be improved? What should Tower focus on
for improvement?
To improve this ROE figure, management could focus on some key variables to
improve overall ROE through greater operational and financial efficiency. This
analysis is based on the relationships that exist between the profitability
indicators and other key ratios, as follows:
Asset Asset
ROS Turnover ROA Leverage
ROE
Net Income X Net Sales = Net Income X Total Assets = Net Income
Net Sales Total Assets Total Assets Net Worth Net Worth
Notice that both asset turnover and asset leverage are multipliers. If these ratios
can be increased without negatively impacting the ROS, then overall ROE will be
increased. This is why it is important for all assets to contribute to sales, and why,
therefore, it is important to avoid allocating resources to unproductive assets.
Obviously, increasing ROS also will ultimately boost ROE if these multipliers do
not decrease.
The asset leverage figure is similar to the traditional debt / equity concept.
Remember, the asset leverage will always be 1.00 greater than the debt leverage
figure. For example, if debt / equity is 1.28, then the asset / equity figure will be
2.28, etc.
Asset Asset
ROS Turnover ROA Leverage ROE
2.4% X 3.05 = 7.3% X 1.81 = 13.3%
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-59
EXERCISE 8.2
PART II
Complete the following projection exercises for both the customer's assumptions and your
own sensitivity analysis assumptions. Enter your figures on the abbreviated spreadsheets
provided for each part of the exercise.
Projection 1: Project the income statement accounts requested. Use the following
customer assumptions for the first projection:
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8-60 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
Calculation
For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20%
respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62%
CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA
expenses. Then insert the figures assumed for depreciation and interest and calculate the
percentages.
INCOME STATEMENT % % %
Sales Growth Rate 15 30 20
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8-62 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Calculation
For each scenario, begin with the 12/31/X3 sales figure and increase by 30% and 20%,
respectively. Calculate the margins based on respective assumptions for CGS (e.g. 62%
CGS / Sales for customer, 65% for sensitivity figures based on historical trends) and SGA
expenses. Then, insert the figures assumed for depreciation and interest and calculate the
percentages.
INCOME STATEMENT % % %
Sales Growth Rate 15 30 20
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-63
EXERCISE 8.2
(Continued)
Projection 2: Project the accounts receivable, inventory, and payables accounts under the
customer's assumptions and under your own sensitivity assumptions. Then,
calculate the amount of increase over the 12/31/X3 numbers. Use the
abbreviated format below.
The methodology for this is based on the relationships in the formulas for
days receivable, days inventory, and days payable.
For example, once we have a figure for sales and the number of days
receivable, we can project the accounts receivable as follows:
Credit Sales
X Number of Days (Sales Terms)
360
We can also project the days inventory figure, now that we have determined
the cost of goods sold and the number of days inventory. The calculation
would be:
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-65
BALANCE SHEET % %* %*
* These vertical analysis percentages cannot be computed until a figure for total assets is projected.
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8-66 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Projection 2: Project the accounts receivable, inventory, and payables accounts under the
customer's assumptions and under your own sensitivity assumptions. Then,
calculate the amount of increase over the 12/31/X3 numbers. Use the
abbreviated format below.
BALANCE SHEET % % %
Calculations
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-67
EXERCISE 8.2
(Continued)
Projection 3: Based on the projections you have calculated, and the following additional
assumptions about the customer's and your own figures, calculate the
projected net funds needs under both the customer's and your own sensitivity
scenarios. The calculation should be Additional Funds Needs less Additional
Funds Sources. Please note:
Customer Sensitivity
+ Additional Funds Needs
Operating:
Increase in Receivables
Increase in Inventory
500 500 Increase in Other Current Assets
Non-Operating:
Capital Expenditures
Reduction of Long-Term Debt
Additional Funds Needs
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8-68 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Projection 3: Based on the projections you have calculated, and the following additional
assumptions about the customer's and your own figures, calculate the
projected net funds needs under both the customer's and your own sensitivity
scenarios. The calculation should be Additional Funds Needs less Additional
Funds Sources. Please note:
Customer Sensitivity
+ Additional Funds Needs
Operating:
6,270 7,581 Increase in Receivables
905 3,218 Increase in Inventory
500 500 Increase in Other Current Assets
Non-Operating:
2,000 2,000 Capital Expenditures
880 880 Reduction of Long-Term Debt
10,555 14,179 Additional Funds Needs
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-69
EXERCISE 8.2
(Continued)
Projection 4: Project the entire balance sheet using the numbers you developed earlier in
this exercise. Enter the numbers in the appropriate boxes below. Note the
following:
BALANCE SHEET % % %
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8-70 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Projection 4: Project the entire balance sheet using the numbers you developed earlier in
this exercise. Enter the numbers in the appropriate boxes below. Note the
following:
BALANCE SHEET % % %
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-71
EXERCISE 8.2
(Continued)
Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio,
and return on average equity figures for both the customer projection and the
sensitivity projection.
RATIO CALCULATIONS
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8-72 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART II
Projection 5: Based on the new balance sheet figures, calculate the leverage, current ratio,
and return on average equity figures for both the customer projection and the
sensitivity projection.
RATIO CALCULATIONS
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-73
EXERCISE 8.2
(Continued)
PART III
Directions: Check your understanding of the Tower Stores, Inc., case by answering the
following questions. Check your answers with the Answer Key that follows.
Question 2: Which account will incur the most significant changes in the company's
future cash generation needs if Teddy Tower proceeds with his more
aggressive marketing ideas?
Question 3: Select the two principal funds sources that Teddy Tower is counting on, in
accordance with his own projections.
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8-74 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
EXERCISE 8.2
(Continued)
Question 4: What is the advisability of approving the customer's request for the increase
in credit facilities?
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-75
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8-76 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
ANSWER KEY
PART III
Summarizing our comments for Question 1 of Part I, we can conclude that the
Tower firm has a strong balance sheet reflecting a healthy liquidity and a
robust capital position. Earnings may be lagging behind expectations from an
investor's point of view, perhaps due to overly conservative management.
Nevertheless, from a creditor's perspective, the numbers indicate a strong
potential for lending — primarily because of the strong capitalization relative to
debt and the considerable stability reflected in the financial figures.
Question 2: Which account will incur the most significant changes in the company's
future cash generation needs if Teddy Tower proceeds with his more
aggressive marketing ideas?
Without any changes in management focus or policies, the situation probably will
continue as in the past. Steady profits and depreciation will be the major elements
of coverage for the company's moderately increasing funds needs. The
remaining funds needs probably will be covered by modest increases in debt,
although leverage probably will remain at similar levels.
If Teddy Tower proceeds with his more aggressive marketing ideas, there may be
significant changes in the financial numbers. Major sales increases will have
parallel (due to growth) and accelerated (due to increased credit sales and terms)
effects on current assets, primarily receivables. These receivables increases will
create funds needs in the range of six to seven million pesos (as calculated in the
customer’s, and our own, sensitivity numbers).
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APPLIED FINANCIAL ANALYSIS — CASE STUDIES 8-77
Teddy proposes to improve the inventory turnover ratio, which will only slightly
increase inventory funds needs (Ps. 905,000 according to his figures).
However, if this improved turnover cannot be achieved and historical ratios are
maintained, the needs would be in the area of three million pesos.
Question 3: Select the two principal funds sources that Teddy Tower is counting on, in
accordance with his own projections.
b) Strong earnings
For sources of funds, Teddy counts on strong earnings increases and significant
increases in credit terms from suppliers, as depicted in our answer to Part II —
Projection Three. If both of these are achieved, then Teddy's outside funds needs
will be minimal. If either of these sources fails by any significant amount, or if
funds needs turn out to be much greater than anticipated, the balance will have to
be covered with outside debt.
In terms of total funds needs, the customer analysis and our own sensitivity
analysis present a wide variance, from less than Ps. one million to ten million
plus. On the asset side, the most critical needs are receivables and inventory;
on the funding side, the most critical variables are earnings and supplier credit.
Earnings may be the most critical variable of all, since higher anticipated debt
levels will generate higher interest payment requirements that must be covered
by increased earnings. If net income cannot be increased in proportion to sales,
the new strategy will be a failure.
The financial feasibility of attaining the customer's figures will then rest on
management's and the firm's abilities to achieve the projected sales with
increased margins, and to control the current assets within the constraints the
customer has fixed for himself. To the extent that implementation of these
policies falls short, funding needs may rise in direct proportion.
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8-78 APPLIED FINANCIAL ANALYSIS — CASE STUDIES
Question 4: What is the advisability of approving the customer's request for the increase
in credit facilities?
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Appendices
APPENDIX A: ACCOUNTING EXERCISE
ANSWER KEY
Assets Liabilities
Cash 50 Short-term bank debt 600
Marketable securities 150 Accounts payable 250
Accounts receivable 500 Accruals 150
Inventory 600 Taxes payable 50
Other current assets 100 Other current liabilities 100
Prepaid expenses 100 Current portion LTD 50
Current Assets 1500 Current liabilities 1200
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A-2 ACCOUNTING EXERCISE
Part 2: Short term Bank Debt, Retained Earnings, Balance Sheet Totals, and Income
Statement Subtotals?
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APPENDIX B:
FINANCIAL STATEMENT STRUCTURE
INTRODUCTION
OBJECTIVES
In this section we will examine the structure of the balance sheet and the income statement.
When you complete this section, you will be able to:
n Describe the purpose of the balance sheet and income statement and classify
their accounts
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B-2 FINANCIAL STATEMENT STRUCTURE
FINANCIAL STATEMENTS
n Balance Sheet
Accrual basis Today, financial statements are almost always prepared on an accrual
basis, which means that events are recognized in the period to which
they refer even if the related cash transaction takes place in another
period. For example, if March rent is payable April 5, it is recognized
as a March expense. If 1989 income tax is paid in 1990, it is still a
1989 expense.
Auditors
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FINANCIAL STATEMENT STRUCTURE B-3
Auditors' As a result of their work, auditors issue a report that presents their
opinions opinion on the reliability of a company's financial statements. It is not
an opinion on the financial health of the company. The analyst
determines whether or not the company is financially healthy.
Qualified Auditors also may qualify their opinions, stating that they do not agree
opinions with the manner in which the company accounted for certain
transactions. In this case, the banker should carefully consider the
qualification and adjust the financial statements for purposes of
financial analysis. For example, if the auditors claim that the company
failed to report certain losses, and the analyst agrees with them, the
analyst must adjust the financial statements for those losses before
performing an analysis.
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B-4 FINANCIAL STATEMENT STRUCTURE
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FINANCIAL STATEMENT STRUCTURE B-5
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B-6 FINANCIAL STATEMENT STRUCTURE
BALANCE SHEET
n Assets
Basic The basic structure of the balance sheet is always the same and can be
accounting translated into this equation:
equation
Assets = Liabilities + Net Worth
Look at the sample balance sheet on page B-5. Notice that assets
and liabilities plus net worth reflect account balances at the end of
a specific period. These accounts indicate the financial position of
CPT, Inc. Let's take a closer look at these accounts.
ASSETS
Asset valuation One of the main accounting principles states that assets should
generally be valued at the lower of cost or market. The principle
works as follows:
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FINANCIAL STATEMENT STRUCTURE B-7
Assets are usually classified in the balance sheet in the order they are
realized.
Realizing assets “Realizing an asset” means to convert it into cash. For example, if
you sell an item for cash, you are realizing it at the same time you
are selling it. However, if you sell it on credit, you only realize it
when the bill is collected. Asset realizations create an inflow of funds
into the company. The earlier an asset can be realized, the more liquid
it is.
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B-8 FINANCIAL STATEMENT STRUCTURE
Of course, not all assets of the same group will be realized on the
same date, which means that asset realizations may create an uneven
inflow of funds.
Current Assets
Example: For example, a company may own shares in another company that can
intend to realize be sold immediately in the stock exchange. However, if the company
intends to keep the shares for more than one year because the
investment is considered profitable, then the shares cannot be labeled
as current assets.
Accounts Cash — Cash on hand plus demand bank deposits and items which will
be converted into cash within approximately 48 hours (such
as undeposited checks). Amounts in foreign currencies must be
translated into local currency at the exchange rates prevailing at
balance sheet date.
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FINANCIAL STATEMENT STRUCTURE B-9
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B-10 FINANCIAL STATEMENT STRUCTURE
Non-Current Assets
You will learn more about depreciation when we discuss the income
statement.
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FINANCIAL STATEMENT STRUCTURE B-11
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B-12 FINANCIAL STATEMENT STRUCTURE
SUMMARY
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FINANCIAL STATEMENT STRUCTURE B-13
n Current assets
n Non-current assets
n Fixed assets
n Other assets
n Current assets
• Cash
• Cash investments
• Trade receivables
• Inventories
• Prepaid expenses
• Other current assets
n Fixed assets
• Long-term receivables
• Investments
• Intangibles
• Deferred charges
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B-14 FINANCIAL STATEMENT STRUCTURE
You have just completed the first section of this supplemental section.
Please complete the following Progress Check before continuing to
the next section, "Liabilities and Net Worth."
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FINANCIAL STATEMENT STRUCTURE B-15
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 2: What are the two most common statements used to determine the financial
position of a company?
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B-16 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
d) accounting.
Question 2: What are the two most common statements used to determine the financial
position of a company?
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FINANCIAL STATEMENT STRUCTURE B-17
Question 3: Indicate whether the following assets are (P) property or (C) claim. The first
one serves as an example.
____
P Vehicles
____ Trade receivables
____ Unfinished products
____ Advances to suppliers
____ Dividends receivable from affiliates
____ Land
____ Stock in other companies
____ Plant machinery
____ Inter-company receivables
____ Raw materials
____ Office building
____ Marketable securities
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B-18 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 3: Indicate whether the following assets are (P) property or (C) claim. The first
one serves as an example.
P Vehicles
C Trade receivables
P Unfinished products
C Advances to suppliers
C Dividends receivable from affiliates
P Land
P Stock in other companies
P Plant machinery
C Inter-company receivables
P Raw materials
P Office building
C Marketable securities
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FINANCIAL STATEMENT STRUCTURE B-19
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B-20 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
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FINANCIAL STATEMENT STRUCTURE B-21
Question 7: Real estate used in the business of an enterprise is classified as a fixed asset
when:
____ a) the company intends to sell it more than one year from balance sheet date.
____ b) the company does not intend to sell it.
____ c) the company intends to sell it within one year of balance sheet date.
____ d) no buyer can be found.
Question 8: The charge for allocating the cost of a fixed asset over its estimated service
life is called:
____ a) appreciation.
____ b) devaluation.
____ c) depreciation.
____ d) cost of doing business.
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B-22 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
d) matures one year or more after balance sheet date and is intended to
be converted to cash at maturity.
Question 7: Real estate used in the business of an enterprise is classified as a fixed asset
when:
Question 8: The charge for allocating the cost of a fixed asset over its estimated service
life is called:
c) depreciation.
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FINANCIAL STATEMENT STRUCTURE B-23
Question 9: Find four current assets in the list below and mark them with the letter "C."
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B-24 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 9: Find four current assets in the list below and mark them with the letter "C."
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FINANCIAL STATEMENT STRUCTURE B-25
Question 10: Fill in the missing values using the assets section of CPT's balance sheet
below.
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B-26 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 10: Fill in the missing values using the assets section of CPT's balance sheet
below.
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FINANCIAL STATEMENT STRUCTURE B-27
Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other.
The first one serves as an example.
19X1 19X2
F
_____ Transportation equipment 400 768
_____ Prepaid expenses 80 64
_____ Inter-company loans 240 0
_____ Deferred charges 200 252
_____ Office building 600 900
_____ Legal deposits 160 256
_____ Cash 40 64
_____ Advances to suppliers 80 192
_____ Marketable securities 200 576
_____ Investment in affiliates 200 320
_____ Trade receivables 880 1,472
_____ Accumulated depreciation (600) (1,024)
_____ Property and plant 1,600 2,820
_____ Inventories 320 384
_____ Machinery and other equipment 1,200 2,176
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B-28 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 11: Classify the following assets as either (C) current, (F) fixed, or (O) other.
The first one serves as an example.
19X1 19X2
F Transportation equipment 400 768
C Prepaid expenses 80 64
O Inter-company loans 240 0
O Deferred charges 200 252
F Office building 600 900
O Legal deposits 160 256
C Cash 40 64
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FINANCIAL STATEMENT STRUCTURE B-29
Question 12: Based on your answers to Question 11, prepare a list of assets for this
company. (Hint: Use the balance sheet model on page B-25 for this
exercise.)
NON-CURRENT ASSETS
Fixed Assets
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
Other Assets
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
TOTAL ASSETS
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B-30 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 12: Based on your answers to Question 11, prepare a list of assets for this
company. (Hint: Use the balance sheet model on page B-25 for this
exercise.)
NON-CURRENT ASSETS
Fixed Assets
Property and Plant 1,600 2,820
Machinery and Other Equipment 1,200 2,176
Transportation Equipment 400 768
Office Buildings 600 900
Accumulated Depreciation (600) (1,024)
PPE, Net 3,200 5,640
Other Assets
Inter-Company Loans 240 0
Legal Deposits 160 256
Deferred Charges 200 252
Investment in Affiliates 200 320
Total Other Assets 800 828
TOTAL ASSETS 5,600 9,220
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FINANCIAL STATEMENT STRUCTURE B-31
Liabilities Liabilities are the claims of others against the company for resources
supplied to the company. An increase in liabilities reflects an increase
in the resources available to the company and also the need to dispose
of assets to settle the liabilities.
n Claims for credit sales, that is, for goods and services supplied
to the company for later payment
Net worth Net worth reflects the wealth invested by shareholders and
accumulated by the company from earnings.
Liabilities
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B-32 FINANCIAL STATEMENT STRUCTURE
n Long-term liabilities
Current Liabilities
Mature within Current liabilities are obligations maturing within one year from
one year balance sheet date. Current liabilities include:
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FINANCIAL STATEMENT STRUCTURE B-33
Long-Term Liabilities
Mature in more Long-term liabilities are obligations maturing more than one year
than one year after balance sheet date. Long-term liabilities include:
Net worth Capital Stock —Amount invested in the company by the owners,
accounts based on share par values, not market or liquidation value. Sometimes
we should add to this the amount of paid-in surplus, which reflects
the excess of the amount actually paid for the shares over the face
value of those securities.
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B-34 FINANCIAL STATEMENT STRUCTURE
Assets used Off-Balance-Sheet Items are assets used, but not owned, by the
but not owned company, and their related liabilities. This usually includes leased
property on the asset side and the related leasing payments on the
liability side. Companies enter into leasing agreements because they
may be advantageous for tax purposes. Since tax regulations vary from
country to country, so do the relative advantages of leasing / owning.
Contingencies
May be assets Contingencies are items which may become assets or liabilities
or liabilities depending on some future event. For instance, if Company A
in the future sues Company B for breach of contract claiming an indemnity of US$
1 million, there are two possibilities:
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FINANCIAL STATEMENT STRUCTURE B-35
SUMMARY
n Current liabilities
n Long-term liabilities
n Current liabilities
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B-36 FINANCIAL STATEMENT STRUCTURE
n Long-term liabilities
• Long-term debt
• Deferred liabilities
• Other long-term liabilities
Net Worth accounts reflect the invested and accumulated wealth of the
stockholders in the enterprise.
n Capital stock
n Reserves
You have now completed the section on "Liabilities and Net Worth."
Please complete the following Progress Check before continuing to
the section entitled "Income Statement."
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FINANCIAL STATEMENT STRUCTURE B-37
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
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B-38 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
c) debt / obligations
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FINANCIAL STATEMENT STRUCTURE B-39
Question 15: Match each of the following liability accounts with its definition.
Question 16: Customer advances are classified as current liabilities when they mature:
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B-40 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 15: Match each of the following liability accounts with its definition.
Question 16: Customer advances are classified as current liabilities when they mature:
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FINANCIAL STATEMENT STRUCTURE B-41
Question 18: A loan maturing in five years is classified as long-term debt. After the fourth
year, it will be:
____ a) forgiven.
____ b) paid off.
____ c) included within current liabilities.
____ d) reclassified as shareholders' equity (net worth).
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B-42 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
b) long-term / current
Question 18: A loan maturing in five years is classified as long-term debt. After the fourth
year, it will be:
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FINANCIAL STATEMENT STRUCTURE B-43
Question 19: Using the liability section of the balance sheet below, fill in the missing
values.
LONG-TERM LIABILITIES
Long-term Debt 8,845 7,355
Long-term Deferred Liabilities 1,863 2,289
Total Long-term Liabilities 10,708 9,644
TOTAL LIABILITIES 35,841 62,174
NET WORTH
Capital Stock 10,000 10,000
Capital Reserves 1,667 2,046
Retained Earnings 7,198 11,172
TOTAL NET WORTH 18,865 23,218
TOTAL LIABILITIES & NET WORTH 54,706 85,392
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B-44 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 19: Using the liability section of the balance sheet below, fill in the missing
values.
A) Liabilities and Net Worth in 19X1 were $35,841 and $18,865 , respectively.
B) Current Liabilities totaled $52,530 in 19X2. This represents the sum of Due to
Banks, Trade Payables, Customer Advances, Accruals, Taxes Payable, Other Current
Liabilities, and the Current Portion of Long-term Debt.
C) Long-term Liabilities totaled $10,708 in 19X1. This represents the sum of Long-
term Debt and Long-term Deferred Liabilities.
D) Stockholder's Equity (Net Worth) totaled $23,218 in 19X2. This represents the sum
of Capital Stock, Capital Reserves, and Retained Earnings.
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FINANCIAL STATEMENT STRUCTURE B-45
Question 20: Classify the following liability accounts as either (C) Current, (L) Long-
term, or (S) Shareholders' Equity (Net Worth).
19X1 19X2
____ Bank loans maturing within 60 days 0 176
____ Capital stock 800 1,260
____ Dividends payable 200 201
____ Fixed asset loan maturing in 3 years 400 512
____ Due to suppliers 480 640
____ Capital reserves 600 1,300
____ Payroll accruals 120 247
____ Income taxes due 240 408
____ Shareholders' loans without agreed maturity 400 168
____ Utility bills 120 72
____ Retained earnings 400 960
____ Other accruals 240 456
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B-46 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 20: Classify the following liability accounts as either (C) Current, (L) Long-
term, or (S) Shareholders' Equity (Net Worth).
19X1 19X2
C Bank loans maturing within 60 days 0 176
S Capital stock 800 1,260
C Dividends payable 200 201
L Fixed asset loan maturing in 3 years 400 512
C Due to suppliers 480 640
S Capital reserves 600 1,300
C Payroll accruals 120 247
C Income taxes due 240 408
L Shareholders' loans without agreed maturity 400 168
C Utility bills 120 72
S Retained earnings 400 960
C Other accruals 240 456
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FINANCIAL STATEMENT STRUCTURE B-47
Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net
Worth accounts for this company. (Hint: Follow the balance sheet model
from Question 19.)
LONG-TERM LIABILITIES
_____________________________________ _________ ________
_____________________________________ _________ ________
NET WORTH
_____________________________________ _________ ________
_____________________________________ _________ ________
_____________________________________ _________ ________
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B-48 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 21: Based on your answers to Question 20, prepare a list of Liabilities and Net
Worth accounts for this company. (Hint: Follow the balance sheet model
from Question 19.)
LONG-TERM LIABILITIES
Fixed Asset Loan Maturing in Three Years 400 512
Shareholders’ Loans Without Agreed Maturity 400 168
Total Long-term Liabilities 800 680
TOTAL LIABILITIES 2,200 2,880
NET WORTH
Capital Stock 800 1,2600
Capital Reserves 600 1,300
Retained Earnings 400 960
TOTAL NET WORTH 1,800 3,520
TOTAL LIABILITIES & NET WORTH 4,000 6,400
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FINANCIAL STATEMENT STRUCTURE B-49
INCOME STATEMENT
When expenses are lower than income, results are positive and the
company is said to have a profit. If income is lower than expenses,
results are negative and the company is said to have a loss.
CPT, INC.
Income Statement
Years ended December 31, 19X1 and 19X2
19X1 19X2
Net Sales 66,540 85,362
– Cost of Goods Sold 43,715 60,077
Gross Profit 22,825 25,285
– Selling, General Admin. Expenses 10,424 12,780
Operating Profit 12,401 12,505
– Depreciation 1,988 2,094
– Financial Expense 4,255 5,694
+ Other Income, Net -405 -904
Earnings Before Taxes 5,753 3,813
– Income Tax 1,640 1,088
+ Extraordinary Items 0 1,440
Net Income 4,113 4,165
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B-50 FINANCIAL STATEMENT STRUCTURE
In some income statements, the last line shows earnings per share,
which is determined by dividing net income by the number of stock
shares outstanding. The general structure is:
= Operating Profit
Minus: Depreciation
Minus: Financial Expense (Net of Financial Income)
Plus: Other Income (Net of Other Expense)
= Pretax Income
Minus: Income Tax
Plus / Minus: Extraordinary Items
= Net Income (After-tax Income)
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FINANCIAL STATEMENT STRUCTURE B-51
Net Sales — Sales revenues net of returns, discounts, and sales taxes.
Most companies sell on credit, and accrual basis accounting principles
require them to recognize the sale when it is made, not when the cash
is received. As a consequence, in those cases, net sales always reflect
uncollected (unrealized) sales in the same amount as shown in
accounts receivable.
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B-52 FINANCIAL STATEMENT STRUCTURE
Net Income — Amount left after all expenses are deducted from
revenues. This amount, less dividends paid, will be reflected in the net
worth section of the balance sheet as a change in retained earnings.
Accounting Principles
• Cost principle
• Realization principle
• Matching principle
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FINANCIAL STATEMENT STRUCTURE B-53
Cost Principle
All items The cost principle states that all items will be recorded at original cost
recorded at (the amount paid for them). This principle ensures that all companies
original cost will be using cost value, not market value, when presenting their
statements.
This may sound strange at first, because market value is very important
when determining the value of a business. However, there is no
objective way for all companies to calculate the current market value
of their properties. The valuation depends on which appraisal method
is used.
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B-54 FINANCIAL STATEMENT STRUCTURE
Realization Principle
Recognize The realization principle states that revenues should be recorded when
revenue when earned, and expenses recorded when incurred; assets should be
earned and recorded when owned, and liabilities should be recorded when owed.
expenses when With this principle, we recognize revenue as we earn it, even though
incurred we might not have received any payment. At the same time, we must
recognize expenses as we incur them, even though we might not have
made any payment.
The quick reader will also realize another effect of the realization
principle. Net income does not equal cash. A company may have
a good net income on paper, but very little money in the bank. For
example, the cash from sales has not yet been received since sales
were made granting generous credit terms. In an opposite situation,
a company may have little or no profit because it is liquidating
inventory at cost or near cost, yet the company has a strong cash
position as a result of this liquidation.
Matching Principle
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FINANCIAL STATEMENT STRUCTURE B-55
SUMMARY
Simply put:
The income statement structure begins with net sales and other
revenues listed first. Expenses are then deducted to determine net
income or loss.
• Cost principle
• Realization principle
• Matching principle
You have now completed the final section of Appendix B. Please complete the following
Progress Check to make sure you understand the concepts presented in this section.
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B-56 FINANCIAL STATEMENT STRUCTURE
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FINANCIAL STATEMENT STRUCTURE B-57
Directions: Select the correct answers for the following questions. There is only one
correct answer unless otherwise stated in the question. Check your answers
with the Answer Key on the next page. If you answer any of the questions
incorrectly, return to the appropriate section of the text and review the
material.
Question 22: Indicate whether the following accounts are (I) income or (E) expense.
____ Payroll
____ Product sales
____ Cost of goods sold
____ Sales commissions
____ Building depreciation
____ Utilities
____ Investment profits
____ Cost of services
____ Selling of goods
____ Dividends received
____ Provision for income tax
____ Cost of maintenance
Question 23: Costs and expenses are deducted from revenues in the income statement to
determine results. Positive results are called ; negative results
are called .
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B-58 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 22: Indicate whether the following accounts are (I) income or (E) expense.
E Payroll
I Product sales
E Cost of goods sold
E Sales commissions
E Building depreciation
E Utilities
I Investment profits
E Cost of services
I Selling of goods
I Dividends received
E Provision for income tax
E Cost of maintenance
Question 23: Costs and expenses are deducted from revenues in the income statement to
determine results. Positive results are called profits ; negative results are
called losses .
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FINANCIAL STATEMENT STRUCTURE B-59
Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash
account. Credit sales increase:
Question 26: The income statement normally shows revenues, expenditures, and costs:
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B-60 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 25: Sales affect certain balance sheet accounts. Cash sales increase the cash
account. Credit sales increase:
c) trade receivables.
Question 26: The income statement normally shows revenues, expenditures, and costs:
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FINANCIAL STATEMENT STRUCTURE B-61
Question 27: Match each of the following revenue and expense accounts to its definition.
____ Selling, General, and Adm. b) Non-recurring gains or losses that result
from activities that are not part of the
____ Depreciation normal operations of the business
c) Interest expense on interest-paying debt
____ Financial Expense
d) Non-cash charge that reduces the book
____ Extraordinary Gains / Losses value of the plant or equipment every
year
____ Net Income
e) Expenses incurred such as management
salaries, cost of advertising, telephones,
etc.
f) Cost of raw materials, labor, and
overhead expenses attributed to the
processing of goods
Question 28: Mark the following statements (T) true or (F) false.
____ a) The income statement only shows all income and expense received
and paid during the period.
____ b) Cost of Goods Sold includes expenditures such as direct labor
expenses, raw materials, and interest.
____ c) Certain asset and liability accounts are related to the income
statement. For instance, credit sales are related to trade receivables;
financial expense is related to bank loans.
____ d) Selling, General, and Administrative expenses represent expenditures
such as advertising, sales commissions, and telephone.
____ e) Extraordinary gains result from normal business operations.
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B-62 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 27: Match each of the following revenue and expense accounts to its definition.
Question 28: Mark the following statements (T) true or (F) false.
F a) The income statement only shows all income and expense received and
paid during the period.
F b) Cost of Goods Sold includes expenditures such as direct labor expenses,
raw materials, and interest.
T c) Certain asset and liability accounts are related to the income statement.
For instance, credit sales are related to trade receivables; financial
expense is related to bank loans.
T d) Selling, General, and Administrative expenses represent expenditures
such as advertising, sales commissions, and telephone.
F e) Extraordinary gains result from normal business operations.
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FINANCIAL STATEMENT STRUCTURE B-63
Question 29: Refer to the Income Statement for CPT, Inc. below and complete the
following questions:
19X1 19X2
Net Sales 66,540 85,362
– Cost of Goods Sold 43,715 60,077
Gross Profit 22,825 25,285
– Selling, General, Admin. Expenses 10,424 12,780
Operating Profit 12,401 12,505
– Depreciation 1,988 2,094
– Financial Expense 4,255 5,694
+ Other Income, Net -405 -904
Earnings Before Taxes 5,753 3,813
– Income Tax 1,640 1,088
+ Extraordinary Items 0 1,440
Net Income 4,113 4,165
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B-64 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 29: Refer to the Income Statement for CPT, Inc. below and complete the
following questions:
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FINANCIAL STATEMENT STRUCTURE B-65
Question 30: Fill in the blanks and compute net income or loss.
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B-66 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 30: Fill in the blanks and compute net income or loss.
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FINANCIAL STATEMENT STRUCTURE B-67
Question 31: Prepare an income statement based on the structure shown in Question 30.
Use the data listed below:
19X1 19X2
Administrative Expense 120 276
Net Sales 3,000 5,100
Selling Expense 290 514
Extraordinary Gain 180 0
General Expense 55 74
Cost of Goods Sold 1,400 2,700
Net Income 678 784
Income Tax 207 321
Depreciation 100 105
Net Financial Expense 350 357
Other Income 20 31
19X1 19X2
Net Sales _________ ________
_______________________________ _________ ________
Operating Profit
_______________________________ _________ ________
_______________________________ _________ ________
_______________________________ _________ ________
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B-68 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
Question 31: Prepare an income statement based on the structure shown in Question 30.
Use the data listed below:
19X1 19X2
Administrative Expense 120 276
Net Sales 3,000 5,100
Selling Expense 290 514
Extraordinary Gain 180 0
General Expense 55 74
Cost of Goods Sold 1,400 2,700
Net Income 678 784
Income Tax 207 321
Depreciation 100 105
Net Financial Expense 350 357
Other Income 20 31
19X1 19X2
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FINANCIAL STATEMENT STRUCTURE B-69
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B-70 FINANCIAL STATEMENT STRUCTURE
ANSWER KEY
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APPENDIX C
GLOSSARY
Acid Test (Quick Asset Ratio) The sum of cash plus near current marketable
securities plus receivables divided by current liabilities; liquidity
ratio
Asset Turnover Ratio obtained by dividing net sales by average total assets; it is an
Ratio indicator of operating efficiency
Capital Stock Balance sheet account showing the amount that shareholders
contributed in exchange for stock
Common Stock Shares that confer voting rights to owners but not preferential
treatment with regard to dividends
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C-2 GLOSSARY
Current Assets Assets that are to be realized or consumed within one year
Earned Surplus (Retained Earnings) Net income accumulated over time less all
dividends paid to stockholders; owners' equity account
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GLOSSARY C-3
Financial Ratio Index or percentage that is derived from dividing one balance sheet
or income statement account by another balance sheet or income
statement account
Fixed Asset Asset which a company does not intend to realize — property,
plant, and equipment
Fixed Assets to Ratio obtained by dividing fixed assets by net worth; measures
Net Worth Ratio the amount of fixed assets covered by own resources
Funds All measurable assets that are available to the company for use
in its operation
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C-4 GLOSSARY
Inventory Operating ratio obtained by dividing cost of goods sold for a period
Turnover by the average inventory for the same period; expresses
in times per year the average time taken to consume inventory
Invested Capital Amount of resources invested and paid in by the shareholders in the
company
Liquidity Ratio Financial index that measures the ability of the enterprise to meet
its short-term financial obligations in a timely manner without
realizing fixed assets; indicates the relationship between current
assets and current liabilities
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GLOSSARY C-5
Margin Analysis Technique for income statement analysis that breaks down
individual revenue and expense accounts into percentages of
net sales
Marketable Money market securities held as very short term investments for
Security the purpose of investing excess funds to maximize return on assets
Monetary Items Assets and liabilities realizable or payable in currency that can
generate gains or losses resulting from inflation or foreign
exchange transactions
Non-current Debts and obligations that mature more than one year from the
Liabilities balance sheet date
Operating Ratio Type of ratio that measures the efficiency and effectiveness of
a company's utilization of its assets
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C-6 GLOSSARY
Paid-in Surplus Excess of the actual amount of capital paid to the company by
shareholders over the par value of purchased shares — an owners'
equity account
Payables Operating ratio indicating the number of times payables are rotated
Turnover Ratio during the period within a firm's annual purchases or
cost of goods sold; obtained by dividing total purchases by
trade payables
Preferred Stock Shares that grant owners priority on receiving dividends but
generally do not grant voting rights — an owners' equity account
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GLOSSARY C-7
Receivables Operating ratio expressing in times per year the average time taken
Turnover Ratio to collect receivables from the balance sheet within the annual net
credit sales; obtained by dividing credit sales by
trade receivables
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C-8 GLOSSARY
Vertical Analysis Technique that breaks down individual assets, liabilities, equities,
and expense accounts into percentages for comparison purposes;
analysis of the financial statements of a single company or across
several companies for a particular period
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Index
INDEX
A
Accounting 1-1—1-6, 1-9, 1-10, 1-12, 1-16, 1-17, 1-25, 1-27, 1-28, 1-32,
1-35, 2-1, 2-3, 2-31, 3-9, 5-10, 6-13, 8-19, 8-42, 8-43, B-1—
B-3, B-6, B-10, B-12, B-51—B-55,
Accounts Payable 1-6, 1-26, 1-28, 2-28, 2-44, 6-23, 6-26, 8-12, B-32, B-35,
Accounts 1-26, 1-28, 1-31, 4-5, 6-3, 6-6, 8-12, 8-45, B-5, B-6, B-9, B-35,
Receivable B-51, C-28, C-44
Acid Test 4-1, 4-3, 4-6—4-8, 7-21
Asset 1-4, 1-7, 1-9, 1-10, 1-12—1-17, 1-25, 1-26, 1-28—1-32, 1-35, 2-
1—2-7, 2-10, 2-11, 2-26—2-30, 2-33, 3-2, 3-10, 3-11, 3-25, 3-
26, 3-28, 4-1, 4-3, 4-17—4-19, 5-1—5-10, 5-12, 5-13, 5-15, 6-1,
6-33, 6-34, 7-3, 7-4, 7-11—7-14, 8-12, 8-41, 8-42, B-5—B-13,
B-31, B-34, B-35, B-51, B-53, B-54,
Asset Turnover 1-11, 1-16, 4-3, 4-5, 4-8, 6-1, 6-2, 6-33, 6-34,
Ratio
B
Balance Sheet 1-5—1-8, 1-10—1-16, 1-25, 1-26, 1-29, 1-31—1-33, 1-35,
2-3, 2-10, 2-26—2-29, 2-32, 4-4, 4-7, 4-8, 4-17, 5-3, 5-4, 5-
6, 5-9, 5-10, 5-14,6-2, 6-5—6-7, 6-13, 6-15, 6-16, 6-26, 6-
34, 7-5, 7-11, 8-2—8-4, 8-12, 8-40—8-43, 8-45, 8-47,
B-1, B-2, B-4—B-8, B-12, B-13, B-31—B-35, B-52, B-53,
C
Capital Stock 1-6, 8-5, B-5, B-33, B-36
Collection Period 6-5, 6-6
Common Stock 8-12
Consolidated 1-11, 5-9, B-35, B-36
Financial Statement
Contingency B-34, B-36
Current Assets 1-6, 1-8, 2-3—2-7, 2-10, 2-28, 3-24, 3-25, 3-28, 4-1, 4-3—4-8,
4-17—4-19, 5-12, 5-13, 6-1, 6-2, 6-13, 7-21, 8-12, 8-44
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I-2 INDEX
C (Continued)
Current 5-11, 5-12, 5-15
Indebtedness Ratio
Current Liabilities 1-6, 1-8, 2-3—2-5, 2-7, 2-10, 2-11, 2-28, 3-11, 4-1, 4-3—4-
7, 4-17—4-19, 5-6, 5-11—5-13, 5-15, 7-21, 8-12, 8-44,
Current Ratio 2-4, 4-1, 4-3—4-8, 4-17—4-19, 6-1,
D
Days Inventory 4-8, 6-1, 6-2, 6-7, 6-13—6-18, 6-28, 7-21
Days Receivable 4-8, 6-1, 6-2, 6-4—6-7, 6-16, 6-26, 6-28, 7-21
Deferred Charges 3-10,B-5, B-12, B-13
Depreciation 1-6, 2-30, 2-31, 2-44, 3-12, 5-14, 8-12, 8-41, 8-44, 8-45,
B-5, B-10, B-12, B-13, B-49—B-51, B-53,
E
Earned Surplus B-34, B-36
F
Financial Credits 2-8, 2-9, 2-11
Financial Ratio 1-34,3-9, 3-28, 4-1—4-3, 4-19, 5-1, 5-16, 6-1, 6-34, 7-1, 7-
11, 7-15, 7-21, 8-2, 8-3, 8-9, 8-39, 8-78
Financial Statement 1-4, 1-5, 1-9—1-11, 1-17, 1-25, 1-26, 1-28, 1-29—1-32, 1-35,
1-36, 2-1, 2-33, 3-1—3-4, 3-9, 3-19, 3-28, 4-1, 6-3, 8-1—8-3,
8-9—8-12, 8-39, 8-44, 8-46, B-1-—B-4, B-7, B-11, B-34—
B-36, B-52, B-53, B-55
Fixed Asset 1-6, 1-10, 1-12, 1-13, 1-16, 1-28, 1-30, 1-33, 2-3, 2-6, 2-7, 2-
30, 2-33, 3-25, 4-17—4-19, 5-1, 5-3—5-8, 5-12, 5-13, 5-15,
5-16, 6-34, 7-13, 7-14, 8-1, 8-3, 8-12, 8-40—8-42, B-7, B-10,
B-13, B-51,B-53
Fixed Assets to 5-1, 5-13, 5-14, 5-16, 5-17
Net Worth Ratio
Funds 1-10, 1-11, 1-26, 1-33, 2-1, 2-4, 2-6, 2-7, 2-11, 2-26—2-33,
3-9, 3-11, 3-13, 4-6, 5-13, 5-14, 5-16, 6-1, 6-27, 8-1—8-3,
8-43, B-7, B-8, B-31, B-51,
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INDEX I-3
H
Horizontal Analysis 3-1, 3-9, 3-13, 3-25—3-28
I
Income Statement 1-5, 1-6, 1-8, 1-26, 1-27, 1-29, 1-31, 1-33, 1-35, 2-9, 2-29, 2-
30, 2-32, 2-33, 3-1, 3-10, 3-12, 3-13, 3-28, 4-8, 6-2, 6-3, 6-
13, 6-16, 6-25, 8-2, 8-3, 8-5, 8-13, 8-40, 8-41, 8-45, 8-48, B-
1, B-2, B-4, B-10, B-12, B-36, B-49—52, B-55
Indebtedness Ratio 5-1, 5-2, 5-7, 5-11, 5-12, 7-21
Indexation 1-9, 1-28, 3-2, 3-9
Intangibles 1-4, 1-9, 1-13—1-15, 1-17, 1-25, 2-30, 5-6, 5-7, B-5, B-11,
B-13
Inventory 1-6, 1-11, 1-12, 2-10, 2-30, 2-31, 2-44, 3-4, 3-10, 4-4, 4-5, 4-
7, 4-8 6-1, 6-2, 6-13—6-18, 6-28, 7-11, 8-3, 8-10, 8-12,
8-44, B-5, B-54
Inventory Turnover 2-10, 6-1, 6-2, 6-7, 6-13—6-15, 6-17, 6-18, 8-45, 8-46
Investments 1-6, 1-28, 2-6, 2-29, 5-13, 7-1, 7-4, 7-5, B-5, B-7, B-9, B-11,
B-13, B-52, B-53
L
Leverage 1-13, 2-9, 4-2, 4-19, 5-1—5-13, 5-15—5-17, 6-34, 7-11—7-15
Liability 1-9, 1-12, 1-13, 1-15, 2-5, 2-9, 2-27, 3-11, 5-8—5-10, 7-21,
8-12, B-5. B-6, B-12, B-14, B-31—B36, B-51, B-54
Liquidity 2-1—2-3, 2-10, 3-28, 4-2—4-8, 4-17—4-19, 5-5, 5-7, 5-12, 5-
15, 6-1, 7-14, 7-21
Liquidity Ratio 4-1—4-3, 4-6—4-8, 4-17, 4-19, 5-1, 6-1
Long-term 5-1, 5-11—5-13, 5-15
Indebtedness Ratio
Long-term B-7, B-11, B-13
Receivables
M
Margin Analysis 3-12
Marketable Security 1-6, B-9
Monetary Correction 1-1, 1-4, 1-29, 1-31, 1-32, 3-2, 8-2, 8-42, 8-43
Monetary Items 1-28—1-31
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I-4 INDEX
N
Net Worth 1-8, 1-13, 1-14, 1-33, 2-1, 2-6, 2-7, 2-9, 2-26—2-28, 3-11,
4-17—4-19, 5-1—5-13, 5-15, 5-16, 7-4, 7-5, 7-9, 7-10, 7-12, 7-
13, 8-1, 8-3, 8-40—8-43, B-5, B-6, B-11, B-14, B-31, B-33, B-
36, B-52
Non-current Assets 1-8, 2-6, 3-10, 8-12, B-5, B-7, B-10, B-11, B-13
Non-current 1-8
Liabilities
O
Off-balance-sheet B-34, B-36
Assets
Off-balance-sheet B-34
Liabilities
Operating Credits 2-8, 2-11
Operating Ratio 7-21
Owners' Equity 8-12, B-6, B-12, B-36
P
Paid-in Capital 2-8, 2-11
Paid-in Surplus B-33
Payables Turnover 6-1, 6-2, 6-18, 6-23, 6-28
Ratio
Permanent Capital 2-6, 2-11, 5-12
PPE 3-10, B-5, B-10
Prepaid Expenses 1-6, 4-6, 8-12, B-5, B-9, B-10, B-12, B-13
Profit on Sales 7-2
Profitability Ratio 4-3, 7-1, 7-2, 7-11, 7-13
Q
Quick Asset Ratio 4-1, 4-3, 4-4—4-8
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INDEX I-5
R
Realizing B-7
Receivables 6-1—6-3, 6-6, 6-7, 6-13
Turnover Ratio
Reserves B-5, B-33, B-36
Retained Earnings 1-6, 1-8, 1-30, 2-8, 2-11, 2-23, 3-11, 8-12, B-5, B-34, B-36,
B-52
Return on Assets 7-1, 7-3, 7-4, 7-11—7-13, 7-15
Return on Capital 7-4, 7-6
Return on Equity 5-4, 5-5, 7-1, 7-4, 7-5, 7-12—7-15
Return on Sales 7-1, 7-2, 7-11—7-15
Revaluation 1-12, 1-13, 5-7, 5-8, 8-41, 8-42, B-53
S
Shareholders' Equity 2-6, 2-11, B-6, B-33
T
Tangible Net Worth 1-13, 1-14, 5-6—5-8, 7-21
Third Party Capital 2-7—2-11, 2-25, 5-10
Total Indebtedness 5-1, 5-2, 5-7, 5-11, 5-15, 7-21
Ratio
Trade Receivables 3-10, 4-4—4-7, 6-1—6-4, 6-6, 6-7, 7-21, 8-11, B-5, B-9, B-
11, B-13
V
Vertical Analysis 3-1, 3-9—3-13, 3-25, 8-9
W
Working Capital 2-1, 2-3—2-7, 2-10, 2-11, 2-33, 4-5, 4-8, 5-12, 5-13, 5-15,
5-16, 6-16, 6-27, 6-28, 8-10, 8-46
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