Chapter 03

Part2
FinancialTools
ChaptersinthisPart
Chapter3
FinancialStatementsandRatioAnalysis
Chapter4
CashFlowandFinancialPlanning
Chapter5
TimeValueofMoney
Integrative Case 2: Track Software, Inc.
Chapter3
FinancialStatementsandRatioAnalysis
Instructors Resources
Overview
2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter3FinancialStatementsandRatioAnalysis25
Thischapterexaminesfourkeycomponentsofthestockholdersreport:theincomestatement,balance
sheet,statementofretainedearnings,andthestatementofcashflows.Ontheincomestatementandbalance
sheet,themajoraccounts/balancesarereviewedforthestudent.Therulesforconsolidatingacompanys
foreignanddomesticfinancialstatements(FASBNo.52)aredescribed.Followingthefinancialstatement
coveragethechaptercoverstheevaluationoffinancialstatementsusingthetechniqueofratioanalysis.
Ratioanalysisisusedbyprospectiveshareholders,creditors,andthefirmsownmanagementtomeasure
thefirmsoperatingandfinancialhealth.Threetypesofcomparativeanalysisaredefined:crosssectional
analysis,timeseriesanalysis,andcombinedanalysis.Theratiosaredividedintofivebasiccategories:
liquidity,activity,debt,profitability,andmarket.Eachratioisdefinedandcalculatedusingthefinancial
statementsoftheBartlettCompany.Abriefexplanationoftheimplicationsofdeviationfromindustry
standardratiosisoffered,withacomplete(crosssectionalandtimeseries)ratioanalysisofBartlettCompany
endingthechapter.TheDuPontsystemofanalysisisalsointegratedintotheexample.Theimportanceof
understandingfinancialstatementsishighlightedthroughdiscussionsofhowsuchknowledgewillhelpthe
studentbeamoreefficientbusinessmanagerandmoreeffectivelymakepersonalfinancialdecisions.
Suggested Answer to Opener in Review Question

InthechapteropeneryoureadabouthowfinancialanalystsgaveAbercrombiesstockarelatively
positiveoutlookbasedonacurrentratioof2.79,aquickratioof1.79,andareceivablescollection
periodof43days.Basedonwhatyoulearnedinthischapter,doyouagreewiththeanalysts
assessment?Explainwhyorwhynot.
Analystsattempttosimplifythejobofcompanyvaluationusingratiosdrawnfromfinancialreports.
Unfortunately,financialreportscoverpastperiodsandcannotpredictthefuturewith20/20vision.
Nonetheless,theanalystsmayhaveoversimplifiedtheanalysisiftheybasedtheiranalysisprimarilyon
Abercrombiesliquidityratios.Otherratiosshouldhaveplayedagreaterrole.Also,theanalystsshould
havebeenstudyingdomesticandforeigneconomicconditions,includingforecaststhereoftogaininsight
toAbercrombiesfuture.
Answers to Review Questions

1. TheroleoftheFinancialAccountingStandardsBoard(FASB)andPublicCompanyAccounting
OversightBoard(PCAOB)regulatoryagenciesinthefinancialreportingofbusinessesishighly
significant.Thegeneralacceptedaccountingstandardsthatfirmsmustcomplywithandtheprocedures
inmonitoringthosestandardsarereferredtoasgenerallyacceptedaccountingprocedures(GAAP)
andareestablishedprimarilybytheFASB.ThePCAOBhasasoneofitsprimarydutiesservingas
thewatchdogoverthepublicaccountingprofession.Publicaccountingfirmshavereportsthatmust
besubmittedtothePCAOBdocumentingcompliancewithauditingstandardsestablishedbythe
PCAOB.BoththeprocessofmonitoringtheaccountantsandtheuseofGAAPinfinancialreporting
arenecessarytorestoreandmaintainpublicconfidenceinthefinancialinformationdistributedto
thepublic.
2. Thepurposeofeachofthefourmajorfinancialstatementsare:
IncomeStatementThepurposeoftheincomestatementistoprovideafinancialsummaryofthe
firmsoperatingresultsduringaspecifiedtimeperiod.Itincludesboththesalesforthefirmand
thecostsincurredingeneratingthosesales.Otherexpenses,suchastaxes,arealsoincludedon
thisstatement.
BalanceSheetThepurposeofthebalancesheetistopresentasummaryoftheassetsownedbythe
firm,theliabilitiesowedbythefirm,andthenetfinancialpositionoftheownersasofagivenpoint
intime.Theassetsareoftenreferredtoasinvestmentsandtheliabilitiesandownersequityas
financing.
StatementofRetainedEarningsThisstatementreconcilesthenetincomeearnedduringtheyear,
andanycashdividendspaid,withthechangeinretainedearningsduringtheyear.
StatementofCashFlowsThisstatementprovidesasummaryofthecashinflowsandthecash
outflowsexperiencedbythefirmduringtheperiodofconcern.Theinflowsandoutflowsaregrouped
intothecashflowareasofoperations,investment,andfinancing.
3. Thenotestothefinancialstatementsareimportantbecausetheyprovidedetailedinformationnot
directlyavailableinthefinancialstatements.Thefootnotesprovideinformationonaccounting
policies,procedures,calculation,andtransactionsunderlyingentriesinthefinancialstatements.
4. FinancialAccountingStandardsBoardStatementNo.52describestherulesforconsolidatinga
companysforeignanddomesticfinancialstatements.ItrequiresU.S.basedcompaniestotranslate
foreigncurrencydenominatedassetsandliabilitiesintoU.S.dollarsusingthecurrentrate(translation)
method.Thismethodusestheexchangerateprevailingonthedatethefiscalyearends(thecurrent
rate).Incomestatementitemscanbetranslatedusingeitherthecurrentrateoranaverageexchange
ratefortheperiodcoveredbythestatement.Equityaccountsareconvertedattheexchangerateon
thedateoftheinvestment.Intheretainedearningsaccountanygainsandlossesfromcurrencyfluctuations
arestatedseparatelyinanequityreserveaccount thecumulativetranslationadjustmentaccount and
notrealizeduntiltheparentcompanysellsorclosestheforeignoperations.
5. Currentandprospectiveshareholdersplaceprimaryemphasisonthefirmscurrentandfuturelevel
ofriskandreturnasmeasuresofprofitability,whilecreditorsaremoreconcernedwithshortterm
liquiditymeasuresofdebt.Stockholdersarethereforemostinterestedinincomestatementmeasures,
andcreditorsaremostconcernedwithbalancesheetmeasures.Managementisconcernedwithall
ratiomeasures,sincetheyrecognizethatstockholdersandcreditorsmustseegoodratiosinorderto
keepthestockpriceupandraisenewfunds.
6. Crosssectionalcomparisonsaremadebycomparingsimilarratiosforfirmswithinthesameindustry,
ortoanindustryaverage,asofsomepointintime.Timeseriescomparisonsaremadebycomparing
similarratiosforafirmmeasuredatvariouspointsintime.Benchmarkingisthetermusedto
describethiscrosssectionalcomparisonwithcompetitorfirms.
7. Theanalystshoulddevoteprimaryattentiontoanysignificantdeviationsfromthenorm,whether
aboveorbelow.Positivedeviationsfromthenormarenotnecessarilyfavorable.Anabovenormal
inventoryturnoverratiomayindicatehighlyefficientinventorymanagementbutmayalsoreveal
excessivelylowinventorylevelsresultinginstockouts.Furtherexaminationintothedeviationwould
berequired.
8. Comparingfinancialstatementsfromdifferentpointsintheyearcanresultininaccurateandmisleading
analysisduetotheeffectsofseasonality.Levelsofcurrentassetscanfluctuatesignificantly,depending
onacompanysbusiness,sostatementsfromthesamemonthoryearendshouldbeusedintheanalysis
toensurevalidcomparisonsofperformance.
9. Thecurrentratioprovestobethebetterliquiditymeasurewhenallofthefirmscurrentassetsare
reasonablyliquid.Thequickratiowouldprovetobethesuperiormeasureiftheinventoryofthe
firmisconsideredtolacktheabilitytobeeasilyconvertedintocash.
10. Largebusinessestypicallyhaveestablishedrelationshipswithbanksthatcanprovideaccesstoshort
termfundsintheeventthatthefirmhasaneedforliquidity.WholeFoods,thenaturalandorganic
grocerystore,needstohavemorerapidturnoverthaneventhetypicalgrocerystoreinordertokeep
freshproduceontheshelves.Itoffersamorefocusedfoodselection,reducingitsinventoryand
increasingitsinventoryturnoverratio.
11. Additionalinformationisnecessarytoassesshowwellafirmcollectsreceivablesandmeets
payables.Theaveragecollectionperiodofreceivablesshouldbecomparedtoafirmsowncredit
terms.Theaveragepaymentperiodshouldbecomparedtothecreditorscreditterms.
12. Financialleverageisthetermusedtodescribethemagnificationofriskandreturnintroduced
throughtheuseoffixedcostfinancing,suchasdebtandpreferredstock.
13. Thedebtratioandthedebtequityratiomaybeusedtomeasurethefirmsdegreeofindebtedness.
Thetimesinterestearnedandthefixedpaymentcoverageratioscanbeusedtoassessthefirms
abilitytomeetfixedpaymentsassociatedwithdebt.
14. Threeratiosofprofitabilityfoundonacommonsizeincomestatementare:(1)thegrossprofit
margin,(2)theoperatingprofitmargin,and(3)thenetprofitmargin.
15. Firmsthathavehighgrossprofitmarginsandlownetprofitmarginshavehighlevelsofexpenses
otherthancostofgoodssold.Inthiscase,thehighexpensesmorethancompensateforthelow
costofgoodssold(i.e.,highgrossprofitmargin),therebyresultinginalownetprofitmargin.
16. Theownersareprobablymostinterestedinthereturnonequity(ROE)sinceitindicatestherateof
returntheyearnontheirinvestmentinthefirm.ROEiscalculatedbytakingearningsavailableto
commonshareholderanddividingbystockholdersequity.
17. Thepriceearningsratio(P/E)isthemarketpricepershareofcommonstockdividedbytheearnings
pershare.Itindicatestheamounttheinvestoriswillingtopayforeachdollarofearnings.Itisused
toassesstheownersappraisalofthevalueofthefirmsearnings.TheleveloftheP/Eratioindicates
thedegreeofconfidencethatinvestorshaveinthefirmsfuture.Themarket/book(M/B)ratioisthe
marketpriceperofcommonstockdividedbythefirmsbookvaluepershare.FirmswithhighM/B
ratiosareexpectedtoperformbetterthanfirmswithlowerrelativeM/Bvalues.
18. Liquidityratiosmeasurehowwellthefirmcanmeetitscurrent(shortterm)obligationswhenthey
comedue.
Activityratiosareusedtomeasurethespeedwithwhichvariousaccountsareconverted(orcouldbe
converted)intocashorsales.
Debtratiosmeasurehowmuchofthefirmisfinancedwithotherpeoplesmoneyandthefirms
abilitytomeetfixedcharges.
Profitabilityratiosmeasureafirmsreturnwithrespecttosales,assets,orequity.
Marketratiosgiveinsightintohowwellinvestorsinthemarketplacefeelthefirmisdoinginterms
ofreturnandrisk.
Theliquidityanddebtratiosaremostimportanttopresentanyprospectivecreditors.
19. Theanalystmayapproachacompleteratioanalysisoneitheracrosssectionalortimeseriesbasis
bysummarizingtheratiosintotheirfivekeyareas:liquidity,activity,debt,profitability,andmarket.
Eachofthekeyareascouldthenbesummarized,highlightingspecificratiosthatshouldbeinvestigated.
20. TheDuPontsystemofanalysiscombinesprofitability(thenetprofitmargin),assetefficiency
(thetotalassetturnover)andleverage(thedebtratio).ThedivisionofROEamongthesethree
ratiosallowstheanalysttothesegregatethespecificfactorsthatarecontributingtotheROEinto
profitability,assetefficiency,ortheuseofdebt.
Suggested Answer to Global Focus Box: More Countries Adopt

International Financial Reporting Standards
WhatcostsandbenefitsmightbeassociatedwithaswitchtoIFRSintheUnitedStates?
ThetwokeycharacteristicsofthecurrentsystemoffinancialmarketsrelatedtocompaniesfollowingU.S.
GAAPpertaintothecorporatecostofcapitalandinvestorreturn.First,companiesseekingcapitalinthe
U.S.incurthelowestcostoffinancingintheworld.Second,asaconsequence,U.S.investorsreapthe
highestexpectedreturnsontheirinvestmentwhencomparedtoanyotherworldfinancialmarkets.
Manybelievethathavinggoodaccountingrulesisafundamentalreasonforwhyitworkssowell.Thatwe
havegoodrules(betterthananyothersetevercreated)resultsfromaprocessthathasevolvedovertheyears.
Essentially,manyU.S.executiveswhoruncorporationswillbend/break/disregardanyrulethatgetsinthe
wayofreportingnumberstheexecutiveswantreported.U.S.auditorshavehadlittlesuccessovertheyears
ingettingcompaniestoreportgoodfaith,honestnumbers.Therehavebeencyclesofprosecutorstaking
companyexecstocourt,courtsrequiringmorespecificrulesforconvictions,andthenrulemakerstightening
therules.ItisfrequentlysaidthatAmericanaccountingrulesnowhavemanybrightlinesthatcompanies
mustabsolutelyfollowwhentheypreparefinancialstatements.Theentiresystemofcomplianceand
jurisprudencehasresultedintheU.S.makingveryexpensiveinvestmentsincreatingtheaccountingrules.
IFRSrules,whileastepupformany(orevenmost)ofthecountriesthathaveadoptedthem,actually
representastepbackwardsfortheU.S.,atleastinthebrightlinedepartment.SupportersofIFRSsaythe
brightlinesarenotneededbecausecompanyexecsaresupposedtodowhatisright.Thereareexceptions,
suchasthereportingforcontingencies,butforthemostpartitisU.S.GAAPthathasbrightlinesand
IFRSthatdoesnt.Consequently,companiesthatuseIFRSgettomassagetheirnumbers,andreported
earningsareatleast1015%higheronaverageunderIFRSthanGAAP.
Suggested Answer to Focus on Ethics Box: Taking Earnings

Reports at Face Value
Whymightfinancialmanagersbetemptedtomanageearnings?
Financialmanagersincentivestructuresmighttemptthemtomanageearnings.Formanymanagers,
compensationistiedtotheirfirmsstockprice.Thisgivesmanagerstheincentivetotakeactionsthat
increasethestockprice.Ifearningsmanagementaccomplishesthis,managerscouldbetemptedtomanage
earnings.Additionally,financialmanagerscontinuedemploymentwiththefirmisgenerallycontingent
onfirmperformance.
Isitunethicalformanagerstomanageearningsiftheydisclosetheiractivitiestoinvestors?
Earningsmanagementisgenerallydesignedtomisleadinvestors.Actionstakenunderthispremiseare
generallyconsideredunethicalevenwhendisclosed.
Answers to Warm-Up Exercises

E31.
Prepareanincomestatement.
Answer:
a.
NameofCompany
IncomeStatement($000,000)
Salesrevenue
Less:Costofgoodssold
Grossprofits
Less:Operatingexpenses
Salesexpense
Generalandadministrativeexpenses
Leaseexpense
Depreciationexpense
Totaloperatingexpense
Operatingprofits(EBIT)
Less:Interestexpense
$345.0
255.0
$90.0
$18.0
22.0
4.0
25.0
$69.0
$21.0
3.0
Netprofitbeforetaxes
Less:Taxes(rate35%)
Netprofitsaftertaxes
Lessdividends($1.10x4.25millionshares)
Earningsavailableforcommonstockholders
$18.0
6.3
$11.7
4.675
$7.025
b. Seeincomestatement(thisamountstoabout$2.75pershare).
c. Additionstoretainedearningsistheportionleftafterpayingdividends,or$7,012,500.
E32.
Incomestatementsandbalancestatements
Answer: Fromthetableina,thereadercanseethatthecalculationsbeginwithsalesrevenueandend
withnetprofitsaftertaxes.Hadtherebeenalossfortheyear,thefinalresultwouldhavebeen
anetlossaftertaxes.
Thebalancestatementbalancesthefirmsassetsagainstitsfinancing,whichcanbeeitherdebt
orequity.Thetotalvalueofallofthefirmsassetsshouldequalthesumofitsshortandlong
termdebtplusstockholdersequityincludingpreferredstock,commonstockatparvalue,paid
incapitalinexcessofparoncommonstockandretainedearningsfrompreviousprofitable
yearsinwhichsomeoftheearningswereheldbackandnotpaidoutasdividends.
E33.
Statementofretainedearnings
Answer:
CooperIndustries,Inc.
StatementofRetainedEarnings($000)
fortheYearEndedDecember31,2012
Retainedearningsbalance(January1,2011)
Plus:Netprofitsaftertaxes(for2012)
Less:Cashdividends(paidduring2012)
Preferredstock
Commonstock
Totaldividendspaid
Retainedearningsbalance(December31,2012)
$25,320
5,150
750
3,850
4,600
$25,870
E34.
Currentratiosandquickratios
Answer: Thecurrentratioisincreasingbutthequickratioisdeclining.Sinceinventoryisincludedin
thecalculationofthecurrentratiobutnotinthequickratio,theratiosindicatethatinventory
isincreasingandBluestoneisnotoperatinginaleanmanufacturingmode.Aswithany
analysisusingratios,youshouldinvestigateotherfinancialratiosforBluestonetofurther
assessitsfinancialhealth.
E35.
TheDuPontmethodofcalculatingROE
Answer: ROE4.5%0.721.434.63%
TheadvantageofusingtheDuPontsystemtocalculateROEoverthedirectcalculationofearnings
availableforcommonstockholderscommonstockequityisthatROE,themostcommon
measureforstockholders,isbrokenintothreedistinctcomponents.Startingattherightwesee
howfinancialleveragehasincreasedassetsovertheownersoriginalequity.Next,movingto
theleft,weseehowefficientlythefirmuseditsassetstogeneratesales.Finally,thenetprofit
marginshowsthemeasureofprofitabilityonsales.Eachcomponentcanbecomparedwith
industrystandardstoseeifthefirmisunderperformingoroverperforminginanyoneofthe
threeareas.
Solutions to Problems
P31.
Reviewingbasicfinancialstatements
LG1;Basic
Incomestatement:Inthisoneyearsummaryofthefirmsoperations,Technica,Inc.showeda
netprofitfor2012andtheabilitytopaycashdividendstoitsstockholders.
Balancesheet:ThefinancialconditionofTechnica,Inc.atDecember31,2011and2012isshown
asasummaryofassetsandliabilities.Technica,Inc.hasanexcessofcurrentassetsovercurrent
liabilities,demonstratingliquidity.Thefirmsfixedassetsrepresentoveronehalfoftotalassets
($270,000of$408,300).Thefirmisfinancedbyshorttermdebt,longtermdebt,commonstock,
andretainedearnings.Itappearsthatitrepurchased500sharesofcommonstockin2012.
Statementofretainedearnings:Technica,Inc.earnedanetprofitof$42,900in2012andpaid
out$20,000incashdividends.Thereconciliationoftheretainedearningsaccountfrom$50,200
to$73,100showsthenetamount($22,900)retainedbythefirm.
P32.
Financialstatementaccountidentification
LG1;Basic
(a)
(b)
Statement
TypeofAccount
Accountspayable
BS
CL
Accountsreceivable
BS
CA
Accruals
BS
CL
Accumulateddepreciation
BS
FA*
Administrativeexpense
IS
Buildings
BS
FA
Cash
BS
CA
AccountName
Commonstock(atpar)
BS
SE
Costofgoodssold
IS
Depreciation
IS
Equipment
BS
FA
Generalexpense
IS
Interestexpense
IS
Inventories
BS
CA
Land
BS
FA
Longtermdebt
BS
LTD
Machinery
BS
FA
Marketablesecurities
BS
CA
Notespayable
BS
CL
Operatingexpense
IS
Paidincapitalinexcessofpar
BS
SE
Preferredstock
BS
SE
Preferredstockdividends
IS
Retainedearnings
BS
SE
Salesrevenue
IS
Sellingexpense
IS
Taxes
IS
Vehicles
BS
FA
Thisisreallynotafixedasset,butachargeagainstafixedasset,betterknownasacontraasset.
P33.
Incomestatementpreparation
LG1;Intermediate
a.
CathyChen,CPA
IncomeStatement
Salesrevenue
Less:Operatingexpenses
Salaries
Employmenttaxesandbenefits
Supplies
Travel&entertainment
Leasepayment
Depreciationexpense
Totaloperatingexpense
Operatingprofits
Netprofitsbeforetaxes
Less:Taxes(30%)
$360,000
180,000
34,600
10,400
17,000
32,400
15,600
290,000
$70,000
15,000
$55,000
16,500
$38,500
b. Inherfirstyearofbusiness,CathyChencoveredallheroperatingexpensesandearnedanet
profitof$38,500onrevenuesof$360,000.
P34.
Personalfinance:Incomestatementpreparation
LG1;Intermediate
a.
Adamssalary
$45,000
Arinssalary
30,000
Interestreceived
500
Dividendsreceived
150
TotalIncome
$75,650
Expenses
Mortgagepayments
14,000
Utilityexpense
3,200
Groceries
2,200
Autoloanpayment
3,300
Homeinsurance
750
Autoinsurance
600
Medicalexpenses
1,500
Propertytaxes
1,659
Incometaxandsocialsecurity
13,000
Clothesandaccessories
2,000
Gasandautorepair
2,100
Entertainment
2,000
TotalExpenses
$46,309
CashSurplusor(Deficit)
$29,341
b. Sinceincomeexceedsexpenses,theAdamshaveacashsurplus.
c.
P35.
Thecashsurpluscanbeusedforavarietyofpurposes.Intheshortterm,theymayreplace
theircar,buybetterfurniture,ormorequicklypayofftheirhome.Alternatively,theymay
purchasestocksandbonds,orincreasetheirsavingsforfutureneeds.Investmentsinthestock
marketaregenerallydesignedtoincreaseanindividualsfuturewealth,thepurchaseofbonds
typicallyallowsonetoatleastretaintheirpurchasingpower,whileinvestmentinsavings
accountsprovidesliquidity.
CalculationofEPSandretainedearnings
LG1;Intermediate
a.
Earningspershare:
Netprofitbeforetaxes
$218,000
Less:Taxesat40%
87,200
Netprofitaftertax
$130,800
Less:Preferredstockdividends
Earningsavailabletocommonstockholders
32,000
$98,800
Earningspershare
Earningavailabletocommonstockholders $98,800
$1.162
Totalsharesoutstanding
85,000
b. Amounttoretainedearnings:
85,000shares$0.80$68,000commonstockdividends
Earningsavailabletocommonshareholders
Less:Commonstockdividends
Toretainedearnings
P36.
Incomestatementpreparation
LG1;Intermediate
OwenDavisCompany
BalanceSheet
December31,2012
Assets
Currentassets:
Cash
Accountsreceivable
Inventories
Totalcurrentassets
Grossfixedassets
Landandbuildings
Machineryandequipment
Furnitureandfixtures
Vehicles
Totalgrossfixedassets
Less:Accumulateddepreciation
Netfixedassets
Totalassets
$215,000
75,000
450,000
375,000
$1,115,000
$325,000
560,000
170,000
25,000
$1,080,000
265,000
$815,000
$1,930,000
$98,800
68,000
$30,800
Liabilitiesandstockholdersequity
Currentliabilities:
Accountspayable
Notespayable
Accruals
Totalcurrentliabilities
Longtermdebt
Totalliabilities
Stockholdersequity
Preferredstock
Commonstock(atpar)
Paidincapitalinexcessofpar
Retainedearnings
Totalstockholdersequity
Totalliabilitiesandstockholdersequity
P37.
$220,000
475,000
55,000
$750,000
420,000
$1,170,000
$100,000
90,000
360,000
210,000
$760,000
$1,930,000
PersonalFinance:Balancesheetpreparation
LG1;Basic
a.
AdamandArinAdams
BalanceSheet
December31,2012
Assets
LiabilitiesandNetWorth
Cash
$300
Utilitybills
$150
Checking
3,000
Medicalbills
Savings
1,200
Creditcardbalance
2,000
TotalCurrentLiabilities
$2,400
Moneymarketfunds
1,200
250
TotalLiquidAssets
IBMstock
$5,700
2,000
Mortgage
100,000
Autoloan
8,000
Retirementfunds,IRA
2,000
Personalloan
3,000
TotalInvestments
$4,000
TotalLongTermLiabilities
$111,000
TotalRealEstate
$150,000
TotalLiabilities
$113,400
TotalNetWorth
76,500
TotalLiabilitiesandNetWorth
$189,900
2011Sebring
15,000
2010Jeep
8,000
Householdfurnishings
4,200
Jewelryandartwork
3,000
TotalPersonalProperty
$30,200
TotalAssets
$189,900
b. TotalassetsoftheAdamsfamilymustequalitsdebtplustheextenttowhichithaseither
experiencedagaininvalueorpaidthecostofanasset(itsnetworth).
c.
WorkingCapitalTotalLiquidAssetsTotalCurrentLiabilities
WorkingCapital$5,700$2,400$3,300
P38.
Impactofnetincomeonafirmsbalancesheet
LG1;Basic
Beginning
Value
Account
Change
Ending
Value
a.
$35,000
$1,365,000
$1,400,000
b.
Retainedearnings
Longtermdebt
$1,575,000
$2,700,000
$1,365,000
$865,000
$2,940,000
$1,835,000
c.
Retainedearnings
Buildings
$1,575,000
$1,600,000
$865,000
$865,000
$2,440,000
$2,465,000
Retainedearnings
$1,575,000
$865,000
$2,440,000
d.
Nonetchangeinanyaccounts
P39.
Initialsalepriceofcommonstock
LG1;Basic
(Parvalueofcommonstock
Paidincapitalinexcessofpar)
Initialsalesprice
Numberofcommonsharesoutstanding
Initialsalesprice
$225,000 $2,625,000
$9.50pershare
300,000
P310. Statementofretainedearnings
LG1;Intermediate
a.
CashdividendspaidoncommonstockNetprofitsaftertaxespreferred
dividendschangeinretainedearnings
$377,000$47,000(1,048,000$928,000)
$210,000
HayesEnterprises
StatementofRetainedEarnings
Retainedearningsbalance(January1,2011)
Plus:Netprofitsaftertaxes(for2012)
Less:Cashdividends(paidduring2012)
Preferredstock
Commonstock
Retainedearnings(December31,2012)
$928,000
377,000
(47,000)
(210,000)
$1,048,000
Earningspershare
Netprofitaftertax Preferreddividends(EACS* )
Numberofcommonsharesoutstanding
Earningspershare
$377,000 $47,000
$2.36
140,000
b.
Earningsavailabletocommonstockholders
Cashdividendpershare
Totalcashdividend
#shares
Cashdividendpershare
$210,000(fromParta)
$1.50
140,000
c.
P311. Changesinstockholdersequity
LG1;Intermediate
a.
Netincomefor2012changeinretainedearningsdividendspaid
Netincomefor2012($1,500,000$1,000,000)$200,000$700,000
b. Newsharesissuedoutstandingshares2012outstandingshares2011
Newsharesissued1,500,000500,0001,000,000
Averageissuanceprice
Averageissuanceprice
Paidincapital Commonstock
sharesoutstanding
$4,000,000 $1,000,000
$5.00
1,000,000
c.
Originalissuanceprice
Originalissuanceprice
Paidincapital Commonstock
Numberofsharesissued
$500,000 $500,000
$2.00
500,000
d.
P312. Ratiocomparisons
LG2,3,4,5;Basic
a.
Thefourcompaniesareinverydifferentindustries.Theoperatingcharacteristicsoffirms
acrossdifferentindustriesvarysignificantly,resultinginverydifferentratiovalues.
b. Theexplanationforthelowercurrentandquickratiosmostlikelyrestsonthefactthatthese
twoindustriesoperateprimarilyonacashbasis.Theiraccountsreceivablebalancesaregoing
tobemuchlowerthanfortheothertwocompanies.
c.
Highlevelofdebtcanbemaintainedifthefirmhasalarge,predictable,andsteadycashflow.
Utilitiestendtomeetthesecashflowrequirements.Thesoftwarefirmwillhaveveryuncertain
andchangingcashflow.Thesoftwareindustryissubjecttogreatercompetitionresultingin
morevolatilecashflow.
d. Althoughthesoftwareindustryhaspotentiallyhighprofitsandinvestmentreturnperformance,
italsohasalargeamountofuncertaintyassociatedwiththeprofits.Also,byplacingallof
themoneyinonestock,thebenefitsofreducedriskassociatedwithdiversificationarelost.
P313. Liquiditymanagement
LG3;Basic
a.
Currentratio
Quickratio
Networkingcapital
2009
2010
2011
2012
1.88
1.22
$7,950
1.74
1.19
$9,300
1.79
1.24
$9,900
1.55
1.14
$9,600
b. Thepatternindicatesadeterioratingliquidityposition.Thedeclineismostpronouncedfor
thecurrentratiowhichincludesinventory.
c.
Thelowinventoryturnoversuggeststhatliquidityisevenworsethanthedecliningliquidity
measuresindicate.Slowinventoryturnovermayindicateobsoleteinventory.
P314. Personalfinance:Liquidityratio
LG3;Basic
Liquityratio
Totalliquidassets $3,200+$1,000+$800 $5,000
=
=2.38
Totalcurrentdebts
$1,200+$900
$2,100
a.
b. SinceJoshsliquidityratioexceeds1.8,Joshhasmoreliquiditythanhisbenchmarkfriends.
P315. Inventorymanagement
LG3;Basic
a.
Sales
Less:Grossprofit
Costofgoodssold
$4,000,000
$1,600,000
$2,400,000
100%
40%
60%
Averageinventory
$400,000 $800,000 $1,200,000 $200,000

$650,000
4
Inventoryturnover
Costofgoodssold $2,400,000
3.69times
Averageinventory
$650,000
Averageageofinventory
365
98.9days
3.69
b. TheWilkinsManufacturinginventoryturnoverratiosignificantlyexceedstheindustry.
Althoughthismayrepresentefficientinventorymanagement,itmayalsorepresentlow
inventorylevelsresultinginstockouts.
P316. Accountsreceivablemanagement
LG3;Basic
a.
Averagecollectionperiodaccountsreceivableaveragesalesperday
Averagecollectionperiod
$300,000
$300,000
45.62days
$2,400,000 6,575.34
365
Sincetheaverageageofreceivablesisover15daysbeyondthenetdate,attentionshouldbe
directedtoaccountsreceivablemanagement.
b. Thismayexplainthelowerturnoverandhigheraveragecollectionperiod.TheDecember
accountsreceivablebalanceof$300,000maynotbeagoodmeasureoftheaverageaccounts
receivable,therebycausingthecalculatedaveragecollectionperiodtobeoverstated.Italso
suggeststheNovemberfigure(030daysoverdue)isnotacauseforgreatconcern.However,
13%ofallaccountsreceivable(thosearisinginJuly,August,andSeptember)are60daysor
moreoverdueandmaybeasignofpoorreceivablesmanagement.
P317. Interpretingliquidityandactivityratios
LG3;Intermediate
a.
Bluegrassappearstobeholdingexcessinventoryrelativetotheindustry.Thisfactissupported
bythelowinventoryturnoverandthelowquickratio,eventhoughthecurrentratioisabove
theindustryaverage.Thisexcessinventorycouldbeduetoslowsalesrelativetoproduction
orpossiblyfromcarryingobsoleteinventory.
b. TheaccountsreceivableofBluegrassappearstobehighduetothelargenumberofdaysof
salesoutstanding(73vs.theindustryaverageof52days).Animportantquestionforinternal
managementiswhetherthecompanyscreditpolicyistoolenientorcustomersarejustpaying
slowlyorpotentiallynotpayingatall.
c.
Sincethefirmispayingitsaccountspayablein31daysvs.theindustrynormof40days,
Bluegrassmaynotbetakingfulladvantageofcredittermsextendedtothembytheir
suppliers.Byhavingthereceivablescollectionperiodovertwiceaslongasthepayables
paymentperiod,thefirmisfinancingasignificantamountofcurrentassets,possiblyfrom
longtermsources.
d. Thedesireisthatmanagementwillbeabletocurtailthelevelofinventoryeitherbyreducing
productionorencouragingadditionalsalesthroughastrongersalesprogramordiscounts.If
theinventoryisobsolete,thenitmustbewrittenofftogaintheincometaxbenefit.Thefirm
mustalsopushtotrytogettheircustomerstopayearlier.Paymenttimingcanbeincreased
byshorteningcredittermsorprovidingadiscountforearlierpayment.Slowingdownthe
paymentofaccountspayablewouldalsoreducefinancingcosts.
Carryingouttheserecommendationsmaybedifficultbecauseofthepotentiallossofcustomers
duetostrictercreditterms.Thefirmwouldalsonotwanttoincreasetheircostsofpurchases
bydelayingpaymentbeyondanydiscountperiodgivenbytheirsuppliers.
P318. Debtanalysis
LG4;Basic
Ratio
Definition
Calculation
Debt
Debt
Totalassets
$36,500,000
$50,000,000
EBIT
Interest
$3,000,000
$1,000,000
Times
Creek
0.73
Industry
0.51
3.00
7.30
1.19
1.85
Interestearned
Fixed
Payment
Coverage
EBIT Leasepayment
Interest Leasepayments
$3,000,000 $200,000
$1,000,000 $200,000
{[(principalpreferredstock
Dividends)][1(1t)]}
{[($800,000$100,000)]
[1(10.4)]}
BecauseCreekEnterpriseshasamuchhigherdegreeofindebtednessandmuchlowerabilityto
servicedebtthantheaveragefirmintheindustry,theloanshouldberejected.
P319. Commonsizestatementanalysis
LG5;Intermediate
CreekEnterprises
CommonSizeIncomeStatement
fortheYearsEndedDecember31,2011and2012
2012
2011
Salesrevenue
100.0%
100.0%
Less:Costofgoodssold
Grossprofits
70.0%
30.0%
65.9%
34.1%
Less:Operatingexpenses:
Selling
10.0%
12.7%
General
6.0%
6.3%
Leaseexpense
0.7%
0.6%
Depreciation
3.3%
20.0%
3.6%
23.2%
Operatingprofits
10.0%
10.9%
3.3%
1.5%
NetProfitsbeforetaxes
6.7%
9.4%
Less:Taxes
2.7%
4.0%
3.8%
5.6%
Saleshavedeclinedandcostofgoodssoldhasincreasedasapercentageofsales,probablydueto
alossofproductiveefficiency.Operatingexpenseshavedecreasedasapercentofsales;this
appearsfavorableunlessthisdeclinehascontributedtowardthefallinsales.Thelevelofinterest
asapercentageofsaleshasincreasedsignificantly;thisisverifiedbythehighdebtmeasuresin
Problem15,andsuggeststhatthefirmhastoomuchdebt.
Furtheranalysisshouldbedirectedattheincreasedcostofgoodssoldandthehighdebtlevel.
P320. Therelationshipbetweenfinancialleverageandprofitability
LG4,5;Challenge
Debtratio
a.
(1)
totalliabilities
totalassets
$1,000,000
0.10 10%
$10,000,000
$5,000,000
Debtratio Timberland
0.50 50%
$10,000,000
Debtratio Pelican
Timesinterestearned
(2)
earningbeforeinterestandtaxes
interest
$6,250,000
62.5
$100,000
$6,250,000
Timesinterestearned Timberland
12.5
$500,000
Timesinterestearned Pelican
TimberlandhasamuchhigherdegreeoffinancialleveragethandoesPelican.Asaresult,
Timberlandsearningswillbemorevolatile,causingthecommonstockownerstofacegreater
risk.Thisadditionalriskissupportedbythesignificantlylowertimesinterestearnedratioof
Timberland.Pelicancanfaceaverylargereductioninnetincomeandstillbeabletocoverits
interestexpense.
Operatingprofitmargin
b. (1)
operatingprofit
sales
$6,250,000
0.25 25%
$25,000,000
$6,250,000
Operatingprofitmargin Timberland
0.25 25%
$25,000,000
Operatingprofitmargin Pelican
Netprofitmargin
(2)
sales
$3,690,000
0.1476 14.76%
$25,000,000
$3,450,000
Netprofitmargin Timberland
0.138 13.80%
$25,000,000
Netprofitmargin Pelican
Returnontotalassets
(3)
totalassets
$3,690,000
0.369 36.9%
$10,000,000
$3,450,000
Returnontotalassets Timberland
0.345 34.5%
$10,000,000
Returnontotalassets Pelican
Returnoncommonequity
Commonstockequity
(4)
$3,690,000
0.41 41.0%
$9,000,000
$3,450,000
Returnoncommonequity Timberland
0.69 69.0%
$5,000,000
Returnoncommonequity Pelican
PelicanismoreprofitablethanTimberland,asshownbythehigheroperatingprofitmargin,
netprofitmargin,andreturnonassets.However,thereturnonequityforTimberlandis
higherthanthatofPelican.
c.
EventhoughPelicanismoreprofitable,TimberlandhasahigherROEthanPelicandueto
theadditionalfinancialleveragerisk.ThelowerprofitsofTimberlandareduetothefactthat
interestexpenseisdeductedfromEBIT.Timberlandhas$500,000ofinterestexpenseto
Pelicans$100,000.Evenafterthetaxshieldfromtheinteresttaxdeduction($500,000
0.40$200,000),TimberlandsprofitsarelessthanPelicansby$240,000.SinceTimberland
hasahigherrelativeamountofdebt,thestockholdersequityisproportionallyreduced
resultinginthehigherreturntoequitythanthatobtainedbyPelican.ThehigherROEbrings
withithigherlevelsoffinancialriskforTimberlandequityholders.
P321. Ratioproficiency
LG6;Basic
a.
Grossprofit sales grossprofitmargin

Grossprofit $40,000,000 0.8 $32,000,000
b.
Costofgoodssold sales grossprofit

Costofgoodssold $40,000,000 $32,000,000 $8,000,000
c.
Operatingprofit sales operatingprofitmargin

Operatingprofit $40,000,000 0.35 $14,000,000
d.
Operatingexpenses grossprofit operatingprofit

Operatingexpenses $32,000,000 $14,000,000 $18,000,000
e.
Earningsavailableforcommonshareholders
sales netprofitmargin $40,000,000 0.08 $3,200,000
Totalassets
f.
sales
$40,000,000
$20,000,000
totalassetturnover
2
earningsavailableforcommonshareholders
ROE
$3,200,000
Totalcommonequity
$16,000,000
0.20
Totalcommonequity
g.
Accountsreceivable averagecollectionperiod
Accountsreceivable 62.2days
h.
sales
365
$40,000,000
62.2 $109,589.041 $6,816,438.36
365
P322. Crosssectionalratioanalysis
LG6;Intermediate
a.
FoxManufacturingCompany
RatioAnalysis
IndustryAverage
2012
Actual
2012
Currentratio
2.35
1.84
Quickratio
0.87
0.75
Inventoryturnover
4.55times
5.61times
35.8days
20.5days
Totalassetturnover
1.09
1.47
Debtratio
0.30
0.55
Timesinterestearned
Grossprofitmargin
12.3
0.202
8.0
0.233
0.135
0.133
Netprofitmargin
0.091
0.072
Returnontotalassets
0.099
0.105
0.167
$3.10
0.234
$2.15
Earningspershare
Liquidity:Thecurrentandquickratiosshowaweakerpositionrelativetotheindustryaverage.
Activity:Allactivityratiosindicateafasterturnoverofassetscomparedtotheindustry.Further
analysisisnecessarytodeterminewhetherthefirmisinaweakerorstrongerpositionthanthe
industry.Ahigherinventoryturnoverratiomayindicatelowinventory,resultinginstockouts
andlostsales.Ashorteraveragecollectionperiodmayindicateextremelyefficientreceivables
management,anoverlyzealouscreditdepartment,orcredittermsthatprohibitgrowthinsales.
Debt:Thefirmusesmoredebtthantheaveragefirm,resultinginhigherinterestobligations
thatcouldreduceitsabilitytomeetotherfinancialobligations.
Profitability:Thefirmhasahighergrossprofitmarginthantheindustry,indicatingeithera
highersalespriceoralowercostofgoodssold.Theoperatingprofitmarginisinlinewiththe
industry,butthenetprofitmarginislowerthanindustry,anindicationthatexpensesotherthan
costofgoodssoldarehigherthantheindustry.Mostlikely,thedamagingfactorishighinterest
expensesduetoagreaterthanaverageamountofdebt.Theincreasedleverage,however,magnifies
thereturntheownersreceive,asevidencedbythesuperiorROE.
b. FoxManufacturingCompanyneedsimprovementinitsliquidityratiosandpossiblyareduction
initstotalliabilities.Thefirmismorehighlyleveragedthantheaveragefirminitsindustry
andthereforehasmorefinancialrisk.Theprofitabilityofthefirmislowerthanaveragebut
isenhancedbytheuseofdebtinthecapitalstructure,resultinginasuperiorROE.
P323. Financialstatementanalysis
LG6;Intermediate
a.
ZachIndustries
RatioAnalysis
Industry
Average
Currentratio
Quickratio
Inventoryturnover
Debtratio
Timesinterestearned
Grossprofitmargin
Netprofitmargin
Returnontotalassets
Market/bookratio
1.80
0.70
2.50
37.5days
65%
3.8
38%
3.5%
4.0%
9.5%
1.1
Actual
2011
1.84
0.78
2.59
36.5days
67%
4.0
40%
3.6%
4.0%
8.0%
1.2
Actual
2012
1.04
0.38
2.33
57days
61.3%
2.8
34%
4.1%
4.4%
11.3%
1.3
b. Liquidity:ZachIndustriesliquiditypositionhasdeterioratedfrom2011to2012andisinferior
totheindustryaverage.Thefirmmaynotbeabletosatisfyshorttermobligationsasthey
comedue.
Activity:ZachIndustriesabilitytoconvertassetsintocashhasdeterioratedfrom2011to2012.
Examinationintothecauseofthe20.5dayincreaseintheaveragecollectionperiodiswarranted.
Inventoryturnoverhasalsodecreasedfortheperiodunderreviewandisfaircomparedto
industry.Thefirmmaybeholdingslightlyexcessiveinventory.
Debt:ZachIndustriesdebtpositionhasimprovedsince2011andisbelowaverage.Zach
Industriesabilitytoserviceinterestpaymentshasdeterioratedandisbelowtheindustryaverage.
Profitability:AlthoughZachIndustriesgrossprofitmarginisbelowitsindustryaverage,
indicatinghighcostofgoodssold,thefirmhasasuperiornetprofitmarginincomparisonto
average.Thefirmhaslowerthanaverageoperatingexpenses.Thefirmhasasuperiorreturn
oninvestmentandreturnonequityincomparisontotheindustryandshowsanupwardtrend.
Market:ZachIndustriesincreaseintheirmarketpricerelativetotheirbookvaluepershare
indicatesthatthefirmsperformancehasbeeninterpretedasmorepositivein2012thanin
2011anditisalittlehigherthantheindustry.
Overall,thefirmmaintainssuperiorprofitabilityattheriskofilliquidity.Investigationinto
themanagementofaccountsreceivableandinventoryiswarranted.
P324. Integrativecompleteratioanalysis
LG6;Challenge
SterlingCompany
RatioAnalysis
Ratio
Actual
2010
Actual
2011
Actual
2012
Industry
Average TS:TimeSeries
2012
CS:CrossSectional
Currentratio
TS:Improving
1.40
1.55
1.67
1.85
CS:Fair
Quickratio
1.00
0.92
0.88
1.05
TS:Deteriorating
CS:Poor
Inventoryturnover
9.52
9.21
7.89
8.60
TS:Deteriorating
CS:Fair
Averagecollection
period
TS:Improving
45.6days
36.9days
29.2days 35.5days CS:Good
Averagepayment
TS:Unstable
period
Totalassetturnover
59.3days
0.74
61.6days
0.80
53.0days 46.4days CS:Poor

0.83
0.74
TS:Improving
CS:Good
Debtratio
0.20
0.20
0.35
0.30
TS:Increasing
CS:Fair
Timesinterestearned
8.2
7.3
6.5
8.0
TS:Deteriorating
CS:Poor
Fixedpayment
TS:Deteriorating
coverageratio
4.5
4.2
2.3
4.2
CS:Poor
Grossprofitmargin
0.30
0.27
0.25
0.25
TS:Deteriorating
CS:Average
Operatingprofit
TS:Improving
margin
0.12
0.12
0.13
0.10
CS:Good
Netprofitmargin
0.062
0.062
0.066
0.053
TS:Stable
CS:Good
Returnontotal
assets
TS:Stable
0.045
0.050
0.0508
0.040
Returnoncommon
Equity
TS:Improving
0.061
0.067
0.0782
0.066
Earningspershare
(EPS)
$1.75
$2.20
$3.05
$1.50
CS:Good
TS:Unstable
12.0
10.5
13.0
11.2
Market/bookratio
(M/B)
CS:Good
TS:Improving
Price/earnings
(P/E)
CS:Good
CS:Good
TS:Deteriorating
1.20
1.05
1.16
1.10
CS:Fair
Liquidity:SterlingCompanysoverallliquidityasreflectedbythecurrentratioandquickratio
appearstobefollowingdifferenttrends,butisbelowtheindustryaverage.
Activity:Theactivityofaccountsreceivablehasimproved,butinventoryturnoverhas
deterioratedandiscurrentlybelowtheindustryaverage.Thefirmsaveragepaymentperiod
appearstohavespeededupfrom2010,althoughthefirmisstillpayingmoreslowlythanthe
averagecompany.
Debt:Thefirmsdebtratioshaveincreasedfrom2010andareveryclosetotheindustryaverages,
indicatingcurrentlyacceptablevaluesbutanundesirabletrend.Thefirmsfixedpayment
coveragehasdeclinedandiswellbelowtheindustryaveragefigure,indicatingadeteriorationin
servicingability.
Profitability:Thefirmsgrossprofitmargin,whileinlinewiththeindustryaverage,has
declined,probablyduetohighercostofgoodssold.Theoperatingandnetprofitmarginshave
beenstableandarealsoaboveindustryaverages.BoththeROAandtheROEappeartohave
improvedslightlyandarebetterthantheindustryaverages.EPSmadeasignificantincreasein
2011and2012.TheP/Eratioindicatesanincreasingdegreeofinvestorconfidenceinthefirms
futureearningspotential.
Market:ThefirmsP/Eratiowasgoodin2010,fellsignificantlyin2011,butrecoveredin2012.
Theratioisnowabovetheindustryaverage.Themarkettobookratioinitiallyshowedsignsof
improvingin2011and2012.ThemarketsinterpretationofSterlingsearningabilityindicatesa
lotofuncertainty.ThefluctuationintheM/Bratioalsoshowssignsofuncertainty.
Insummary,thefirmneedstoattendtoinventoryandaccountspayableandshouldnotincur
addeddebtsuntilitsleverageandfixedchargecoverageratiosareimproved.Otherthanthese
indicators,thefirmappearstobedoingwell especiallyingeneratingreturnonsales.The
marketseemstohavesomelackofconfidenceinthestabilityofSterlingsfuture.
P325. DuPontsystemofanalysis
LG6;Intermediate
a.
Margin(%)
2012
Johnson
Industry
2011
Johnson
Industry
2010
Johnson
Industry
Turnove
r
ROA(%)
FLMultiple
ROE(%)
4.9
4.1
2.34
2.15
11.47
8.82
1.85
1.64
21.21
14.46
5.8
4.7
2.18
2.13
12.64
10.01
1.75
1.69
22.13
16.92
5.9
5.4
2.11
2.05
12.45
11.07
1.75
1.67
21.79
18.49
b. Profitability:Industrynetprofitmarginsaredecreasing;Johnsonsnetprofitmarginshave
fallenless.
Efficiency:BothindustrysandJohnsonsassetturnoverhaveincreased.
Leverage:OnlyJohnsonshowsanincreaseinleveragefrom2011to2012,whiletheindustry
hashadlessstability.Between2010and2011,leveragefortheindustryincreased,whileit
decreasedbetween2011and2012.
Asaresultofthesechanges,theROEhasfallenforbothJohnsonandtheindustry,but
JohnsonhasexperiencedamuchsmallerdeclineinitsROE.
c.
Areasthatrequirefurtheranalysisareprofitabilityanddebt.Sincethetotalassetturnoveris
increasingandissuperiortothatoftheindustry,Johnsonisgeneratinganappropriatesales
levelforthegivenlevelofassets.Butwhyisthenetprofitmarginfallingforbothindustry
andJohnson?Hastherebeenincreasedcompetitioncausingdownwardpressureonprices?
Isthecostofrawmaterials,labor,orotherexpensesrising?Acommonsizeincomestatement
couldbeusefulindeterminingthecauseofthefallingnetprofitmargin.
Note:Somemanagementteamsattempttomagnifyreturnsthroughtheuseofleverageto
offsetdecliningmargins.Thisstrategyiseffectiveonlywithinanarrowrange.Ahigh
leveragestrategymayactuallyresultinadeclineinstockpriceduetotheincreasedrisk.
P326. Completeratioanalysis,recognizingsignificantdifferences
LG6;Intermediate
a.
HomeHealth,Inc.
Ratio
Currentratio
Quickratio
Inventoryturnover
Totalassetturnover
Debtratio
Timesinterestearned
Grossprofitmargin
Netprofitmargin
Returnontotalassets
Price/earningsratio
Market/bookratio
2011
3.25
2.50
12.80
42.6days
1.40
0.45
4.00
68%
14%
8.3%
11.6%
21.1%
10.7
1.40
2012
Difference
3.00
0.25
2.20
0.30
10.30
2.50
31.4days 11.2days
2.00
0.60
0.62
0.17
3.85
0.15
65%
3%
16%
+2%
8.1%
0.2%
16.2%
4.6%
42.6%
21.5%
9.8
0.9
1.25
0.15
b.
Ratio
Proportional
Difference
Quickratio
12.00%
CompanysFavor
No
Proportional
Difference
7.69%
12.00%
19.53%
26.29%
42.86%
37.78%
3.75%
4.41%
14.29%
2.41%
39.65%
101.90%
8.41%
10.71%
Inventoryturnover
19.53%
No
26.29%
Yes
Totalassetturnover
42.86%
Yes
Debtratio
37.78%
No
14.29%
Yes
Returnontotalassets
39.65%
Yes
101.90%
10.71%
Yes
No
Returnonequity
Market/bookratio
c.
ThemostobviousrelationshipisassociatedwiththeincreaseintheROEvalue.Theincrease
inthisratioisconnectedwiththeincreaseintheROA.ThehigherROAispartiallyattributed
tothehighertotalassetturnover(asreflectedintheDuPontmodel).TheROEincreaseisalso
associatedwiththeslightlyhigherlevelofdebtascapturedbythehigherdebtratio.
P327. Ethicsproblem
LG1;Intermediate
Answerswillvarybyarticlechosen,butingeneralstudentswillreportthatfinancialstatements
aremoretrustworthyifcompanyfinancialexecutivesimplementtheprovisionsofSOX.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Assessing Martin Manufacturings Current Financial Position
MartinManufacturingCompanyisanintegrativecasestudyaddressingfinancialanalysistechniques.
Thecompanyisacapitalintensivefirmthathaspoormanagementofaccountsreceivableandinventory.
Theindustryaverageinventoryturnovercanfluctuatefrom10to100dependingonthemarket.
a. Ratiocalculations
FinancialRatio
2012
Currentratio
Quickratio
Inventoryturnover(times)
Averagecollectionperiod(days)
Totalassetturnover(times)
Debtratio
Timesinterestearned
Grossprofitmargin
Netprofitmargin
Returnontotalassets
Returnonequity
$1,531,181$616,0002.5%
($1,531,181$700,625)$616,0001.3%
$3,704,000$700,6255.3%
$805,556($5,075,000365)58.0%
$5,075,000$3,125,0001.6%
$1,781,250$3,125,00057%
$153,000$93,0001.6%
$1,371,000$5,075,00027%
$36,000$5,075,0000.71%
$36,000$3,125,0001.2%
$36,000$1,343,7502.7%
HistoricalRatios
MartinManufacturingCompany
Actual
2010
Actual
2011
Actual
2012
Industry
Average
Currentratio
1.7
1.8
2.5
1.5
Quickratio
1.0
0.9
1.3
1.2
Inventoryturnover(times)
5.2
5.0
5.3
10.2
50.7
55.8
58.0
46.0
1.5
1.5
1.6
2.0
45.8%
54.3%
2.2
1.9
1.6
2.5
27.5%
28.0%
27.0%
26.0%
Ratio
Averagecollectionperiod(days)
Totalassetturnover(times)
Debtratio
Timesinterestearned
Grossprofitmargin
57%
24.5%
Netprofitmargin
1.1%
1.0%
0.71%
1.2%
Returnontotalassets
1.7%
1.5%
1.2%
2.4%
Returnonequity
3.1%
3.3%
2.7%
3.2%
Price/earningsratio
Market/book
33.5
38.7
34.48
43.4
1.0
1.1
0.89
1.2
b. Liquidity:Thefirmhassufficientcurrentassetstocovercurrentliabilities.Thetrendisupwardand
ismuchhigherthantheindustryaverage.Thisisanunfavorableposition,sinceitindicatestoomuch
inventory.
Activity:Theinventoryturnoverisstablebutmuchlowerthantheindustryaverage.Thisindicates
thefirmisholdingtoomuchinventory.Theaveragecollectionperiodisincreasingandmuchhigher
thantheindustryaverage.Thesearebothindicatorsofaproblemincollectingpayment.
Thetotalassetturnoverratioisstablebutsignificantlylowerthantheindustryaverage.Thisindicates
thatthesalesvolumeisnotsufficientfortheamountofcommittedassets.
Debt:Thedebtratiohasincreasedandissubstantiallyhigherthantheindustryaverage.Thisplaces
thecompanyathighrisk.Typicallyindustrieswithheavycapitalinvestmentandhigheroperating
risktrytominimizefinancialrisk.MartinManufacturinghaspositioneditselfwithbothheavy
operatingandfinancialrisk.Thetimesinterestearnedratioalsoindicatesapotentialdebtservice
problem.Theratioisdecreasingandisfarbelowtheindustryaverage.
Profitability:Thegrossprofitmarginisstableandquitefavorablewhencomparedtotheindustry
average.Thenetprofitmargin,however,isdeterioratingandfarbelowtheindustryaverage.When
thegrossprofitmarginiswithinexpectationsbutthenetprofitmarginistoolow,highinterest
paymentsmaybetoblame.Thehighfinancialleveragehascausedthelowprofitability.
Market:Themarketpriceofthefirmscommonstockshowsweaknessrelativetobothearningsand
bookvalue.ThisresultindicatesabeliefbythemarketthatMartinsabilitytoearnfutureprofitsfaces
increasinguncertaintyasperceivedbythemarket.
c. MartinManufacturingclearlyhasaproblemwithitsinventorylevel,andsalesarenotatanappropriate
levelforitscapitalinvestment.Asaconsequence,thefirmhasacquiredasubstantialamountofdebt
which,duetothehighinterestpaymentsassociatedwiththelargedebtburden,isdepressingprofitability.
Theseproblemsarebeingpickedupbyinvestorsasshownintheirweakmarketratios.
Spreadsheet Exercise
TheanswertoChapter3sDayton,Inc.,financialstatementsspreadsheetproblemislocatedonthe
InstructorsResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thischaptersgroupfocusessolelyonthegroupsshadowfirm.Groupsareaskedtoinvestigateanddescribe
theirfirmslatest10KobtainedfromtheSecuritiesandExchangewebsite(www.sec.gov).Fromthefiling
thegroupsareaskedtocalculatethebasicratiosasdoneinthetext,anddiscusseachratiosimportance.
Thisleadstoacomparisonoftheseratiosoverthemostrecentyears.Thenumberofyearsisuptotheinstructors
discretion.Ashorternumberofyearsisprobablymostdesirablesincethisoftencanbeaccomplishedfrom
thesingle10Kfiling.TheconclusionofthisassignmentiscalculationoftheDuPontanalysisfortheir
shadowfirm.Thisexerciseshouldntrequiremuchassistance,particularlyifstudentshavemadeagood
choicefortheirfirminChapter1.
Modificationscouldincludedroppingtheintertemporalanalysisandfocusingsolelyonthemostrecent
year.Alternatively,groupscouldbeaskedtocomparetheratiosfromtheirshadowfirmwiththeratios
fromanotherfirmwithinthesameindustry.

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Part2

Integrative Case 2: Track Software, Inc.

Suggested Answer to Opener in Review Question

Answers to Review Questions

Suggested Answer to Global Focus Box: More Countries Adopt

Suggested Answer to Focus on Ethics Box: Taking Earnings

Answers to Warm-Up Exercises

Totalliquidassets $3,200+$1,000+$800 $5,000

$400,000 $800,000 $1,200,000 $200,000

Grossprofit sales grossprofitmargin

Costofgoodssold sales grossprofit

Operatingprofit sales operatingprofitmargin

Operatingexpenses grossprofit operatingprofit

29.2days 35.5days CS:Good

53.0days 46.4days CS:Poor

Assessing Martin Manufacturings Current Financial Position

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