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Cambridge Bu siness Publ is hers, 2014

Solut ions Manual, Chapter 5 5-1

Chapter 5

Analyzing and Interpreting FinancialStatements

Learning Objectives coverage by questionMini-

ExercisesExercises Problems

Cases andProjects

LO1Prepare and analyze commonsize financial statements.

15, 16,19, 20

35

LO2 Compute and interpretmeasures of return on investment,including return on equity (ROE),return on assets (ROA), and return onfinancial leverage (ROFL).

14, 17,

21, 22, 2425 - 31, 34

36, 38,

41, 4550

LO3 Disaggregate ROA intoprofitability (profit margin) and

efficiency (asset turnover)components.

14, 17,

21, 22, 24

25, 27 - 31,

34

36, 38,

41, 46, 4748 - 50

LO4 Compute and interpretmeasures of liquidity and solvency.

18, 23 32, 33 37, 39, 42 50

LO5 Appendix 5A: Measure andanalyze the effect of operatingactivities on ROE.

40, 43

LO6 Appendix 5B: Prepareproforma financial statements.

35 44

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Cambridge Bu siness Pub l ishers, 2014

5-2 Financial Acco unting, 4thEdit ion

DISCUSSION QUESTIONSQ5-1. Return on investment measures profitability in relation to the amount of

investment that has been made in the business. A company can alwaysincrease dollar profit by increasing the amount of investment (assuming it is a

profitable investment). So, dollar profits are not necessarily a meaningful way tolook at financial performance. Using return on investment in our analysis,whether as investors or business managers, requires us to focus not only onthe income statement, but also on the balance sheet.

Q5-2. ROE is the sum of return on assets (ROA) and the return that results from theeffective use of financial leverage (ROFL). Increasing leverage increases ROEas long as ROA exceeds the after-tax interest rate. Financial leverage is alsorelated to risk: the risk of potential bankruptcy and the risk of increasedvariability of profits. Companies must, therefore, balance the positive effects offinancial leverage against their potential negative consequences. It is for this

reason that we do not witness companies entirely financed with debt.Q5-3. Gross profit margins can decline because 1) the industry has become more

competitive, and/or the firms products have lost their competitive advantage sothat the company has had to reduce prices or is selling fewer units or 2) productcosts have increased, or 3) the sales mix has changed from higher-margin/slowly-turning products to lower-margin/higher-turning products.Declining gross profit margins are usually viewed negatively. On the otherhand, cost increases that reflect broader economic events or certain strategicproduct mix changes might not be viewed negatively.

Q5-4. Reducing advertising or R&D expenditures can increase current operating profitat the expense of the long-term competitive position of the firm. Expenditureson advertising or R&D are more asset-like and create long-term economicbenefits.

Q5-5. Asset turnover measures the amount of revenue volume compared with theinvestment in an asset. Generally speaking, we want turnover to be higherrather than lower. Turnover measures productivity and an important companyobjective is to make assets as productive as possible. Since turnover is one ofthe components of ROE (via ROA), increasing turnover increases shareholdervalue. Turnover is, therefore, viewed as a value driver.

Q5-6. ROE>ROA implies a positive return on financial leverage. This results fromborrowed funds being invested in operating assets whose return (ROA)

exceeds the cost of borrowing. In this case, borrowing money increases ROE.

Q5-7. Common-size financial statements express balance sheet and incomestatement items in ratio form. Common-size balance sheets express eachasset, liability and equity item as a percentage of total assets and common-sizeincome statements express each line item as a percentage of sales. The ratioform facilitates comparison among firms of different sizes as well as acrosstime for the same firm.

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Q5-8. The asset turnover ratio (AT) is the ratio of sales revenue to average totalassets. The ratio is increased by increasing sales while holding assetsconstant, or by reducing assets without reducing sales. The most effectivemeans of improving the ratio is to increase the efficient utilization of operatingassets. This is done by improving inventory management practices, improving

accounts receivable collection, and improving the efficient use of PP&E.Q5-9. The net in net operating assets, means operating assets net of operating

liabilities. This netting recognizes that a portion of the costs of operating assetsis paid for by parties other than the company. For example, payables andaccrued expenses help fund inventories, wages, utilities, and other operatingcosts. Similarly, long-term operating liabilities also help fund the cost of long-term operating assets. Thus, these long-term operating liabilities are deductedfrom long-term operating assets.

Q5-10. Companies must manage both the income statement and the balance sheet inorder to maximize ROA. This is important, as many managers look only to theincome statement and do not fully appreciate the value added by effectivebalance sheet management. The disaggregation of ROA into its profit marginand turnover components facilitates analysis of these two areas of focus.

Q5-11. There are an infinite number of possible combinations of margin and turnoverthat will yield a given level of ROA. The relative weighting of profit margin andasset turnover is driven in large part by the companys business model. As aresult, since companies in an industry tend to adopt similar business models,industries will generally trend toward points along the margin/turnovercontinuum.

Q5-12. Liquidity refers to how much cash a company has, how much cash is coming in,and how much cash can be raised quickly. Companies must generate cash in

order to pay their debts, pay their employees and provide their shareholders areturn on investment. Cash is, therefore, critical to a companys survival.

Q5-13. Ratio analysis relies on the data presented in the financial statements and is,therefore, dependent on the quality of those statements. Differences in theapplication of GAAP across companies or within the same company acrosstime can affect the reliability of the analysis. Limitations of GAAP itself anddifferences in the make-up of the company (e.g., types of products or industriesin which the company competes) can also affect the usefulness of ratioanalysis.

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MINI EXERCISES

M5-14. (15 minutes)

a. ROE = $5,000/$500,000 = 1%ROA = $20,000/$1,000,000 = 2%ROFL = 1% - 2% = -1%

b. Net profit margin = $5,000/$1,000,000 = 0.5%Asset turnover = $1,000,000/$1,000,000 = 1.0Financial leverage = $1,000,000/$500,000 = 2.0

c. ROFL is negative for Sunder Company, indicating that financial leverage is hurtingthis company. The return on assets is insufficient to cover the interest cost of thedebt. DuPont analysis masks this problem. The financial leverage ratio of 2.0

suggests (incorrectly) that leverage doubled the return.

M5-15. (20 minutes)

TARGET CORPORATIONCommon-size Balance Sheets

2012 2011Cash and cash equivalents. 1.7% 3.9%

Accounts receivable, net. 12.7% 14.1%Inventory . 17.0% 17.4%

Other current assets. 3.9% 4.0%Total current assets.. 35.3% 39.4%Property and equipment, net.. 62.5% 58.3%Other noncurrent assets.. 2.2% 2.3%Total assets 100.0% 100.0%

Accounts payable. 14.7% 15.2%Accrued liabilities.. 7.8% 7.6%Current portion of long-term debt and notes payable............ 8.1% 0.3%Total current liabilities. 30.6% 23.0%Long-term debt.. 29.4% 35.7%

Deferred income taxes. 2.6% 2.1%Other noncurrent liabilities. 3.5% 3.7%Total shareholders' investment. 33.9% 35.4%Total liabilities and shareholders' investment.. 100.0% 100.0%

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M5-16 (20 minutes)

TARGET CORPORATIONCommon-size Income Statement

Year ended: January 28, 2012

Sales.... 98.0%Net credit card revenues.. 2.0%Total revenues 100.0%Cost of sales 68.5%Selling, general and administrative expenses 20.2%Credit card expenses. 0.6%Depreciation and amortization.. 3.1%Earnings before interest expense and income taxes 7.6%Net interest expense.. 1.2%Earnings before income taxes.. 6.4%Provision for income taxes 2.2%

Net earnings 4.2%

M5-17. (15 minutes)

($ millions)a. EWI = $2,929 + $869 x (1-.35) = $3,493.8

Average total assets = ($46,630 + $43,705)/2 = $45,167.5ROA = $3,493.8/$45,167.5 = 7.74%

b. PM = $3,493.8/$69,865 = 5.00%AT = $69,865 /$45,167.5= 1.5475.00% X 1.547 = 7.74%

M5-18. (20 minutes)

a. 2012 current ratio = $16,449 / $14,827 = 1.152011 current ratio = $17,213 / $10,070 = 1.71

2012 quick ratio = ($794 + $5,927) / $14,827 = 0.472011 quick ratio = ($1,712 + $6,153 / $10,070 = 0.78

Both of these ratios declined over the year, as Targets cash balance dropped byabout $1 billion and its borrowings due within the year increased by more than $3.5billion. Current ratio above 1 is good for a retailer and Targets quick ratio is aboutaverage for a retailer. Target is fairly liquid, even with the declines in these ratios,but it would be worthwhile to see whether these changes represent a trend.

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M5-20. (15 minutes)

3M COMPANYCommon-size Income Statements

2011 2010

Net sales..... $29,611 $26,662Operating expenses: 100.0% 100.0%Cost of sales... 53.0% 51.9%Selling general and administrative expenses 20.8% 20.5%Research, development and related expenses. 5.3% 5.4%

Operating income.. 20.9% 22.2%Interest expense and income:

Interest expense. 0.6% 0.7%Interest income -0.1% -0.1%Total 0.5% 0.6%

Income before income taxes and minority interest 20.4% 21.6%

Provision for income taxes 5.7% 6.0%Net income 14.7% 15.6%

M5-21. (20 minutes)

($ millions)a. 2011 EWI = $4,357+ $186 x (1-.35) = $4,477.9

2011 Average total assets = ($31,616 + $30,156)/2 = $30,886ROA = $4,477.9/$30,886 = 14.50%

b. PM = $4,477.9/$29,611 = 15.12%AT = $29,611/($31,616 +$30,156)/2 = 0.95915.12% X 0.959 = 14.50%

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M5-22. (15 minutes)

($ millions)a. URBN: Average total assets = ($1,483.7 + $1,794.3)/2 = $1,639.0

ROA = $185.2/$1,639.0= 11.30%

TJX: Average total assets = ($8,281.6 + $7,971.8)/2 = $8,126.7ROA = $1,526.5 /$8,126.7= 18.78%

b. URBN: PM = $185.2 / $2,473.8= 7.49%AT = $2,473.8 / $1,639.0= 1.517.49% X 1.51 = 11.30%

TJX: PM = $1,526.5 / $23,191.5 = 6.58%AT = $23,191.5 /$8,126.7 = 2.85

6.58% X 2.85 = 18.78%

c. URBNs ROA is less than TJXs. TJX operates in the value-priced segment of itsindustry which explains its lower PM. As is typical of value-priced retailers, TJXsasset turnover is high its AT is almost double that of URBN. On balance, TJXsbusiness model appears to be more successful in 2011 as it is able to maintain botha high AT and a reasonable PM, resulting in higher ROA.

M5-23. (20 minutes)

($ millions)a. Verizons current ratio for the two years presented is as follows:

2011 current ratio: $30,939 / $30,761 = 1.012010 current ratio: $22,348 / $30,597 = 0.73

Liquidity is increasing and in 2011, Verizons current ratio nudged above 1.0. Wemight want to know, however, whether Verizons current assets are concentrated incash or relatively illiquid inventories, as well as the maturity schedule of its currentliabilities. We would also like to know the median current ratio for the industry (1.41).This would help place Verizons numbers in perspective.

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M5-23. concluded

b. Verizons times interest earned ratio for the two years is as follows:

2011 times interest earned = $13,310 / $2,827 = 4.71

2010 times interest earned = $15,207 / $2,523 = 6.03

Verizons times interest earned ratio has decreased, but remains significantly higherthan the industry median (3.12).

2011 debt-to-equity = $144,553 / $85,908 = 1.682010 debt-to-equity = $133,093 / $86,912 = 1.53

Verizons debt-to-equity ratio has increased, and is just slightly below the 1.76median for companies in the telecommunications industry.

Verizons operating cash flow to current liabilities ratio is as follows:2008 OCFCL = $29,780 / [($30,761 + $30,597)/2] = 0.97

c. Verizon is carrying a significant amount of debt. Although its profitability andoperating cash flow are fairly strong, neither is particularly high in relation to thecompanys liabilities and interest costs. Verizons liquidity appears below that ofmany others in its industry, and its debt-to-equity is now just below the median forcommunications companies. There is some question, therefore, regarding theamount of additional debt that the company can take on. Given its significant capitalexpenditure requirements and its current debt load, Verizon may have to fund futurecapital expenditures with higher-cost equity. And, to the extent that its competitorsare not as highly leveraged, this may negatively impact Verizons competitiveposition.

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M5-24. (30 minutes)

a.$ millions Asset Turnover

Procter & Gamble .............. $83,680/$135,299 = 0.62

McDonald's ........................ $27,006/$32,483 = 0.0.83

Valero Energy ................... $125,987/ $40,202 = 3.13

b.$ millions ART

Procter & Gamble .............. $83,680/$6,172 = 13.56

McDonald's ........................ $27,006/$1,257 = 21.48

Valero Energy ................... $125,987/ $6,645 = 18.96

$ millions INVT

Procter & Gamble .............. $42,391/$7,050 = 6.01

McDonald's ........................ $6,167/$113 = 54.58

Valero Energy ................... $115,719/ $5,285 = 21.90

$ millions PPET

Procter & Gamble .............. $83,680/$20,835 = 4.02

McDonald's ........................ $27,006/$22,448 = 1.20

Valero Energy ................... $125,987/ $23,923 = 5.27

c. For all three companies, these ratios reflect differences in their businesses, and theoverall AT ratio is related to the three individual ratios as seen in Exhibit 5.8 in thechapter. Valero has the highes AT: it collects from its customers very quickly andcarries small amounts of inventory relative to its cost of goods sold. It also has thelowest level of property, plant and equipment relative to its sales. Procter &Gambles ratios are influenced by the relative strength of its largest customer (Wal-Mart), resulting in higher inventory levels and slower collections. In addition, P&Ghas a large level of intangible assets, as we will see in Chapter 8, so its PPET is

relatively high, but its AT is the lowest of the three. McDonalds inventory turnover isvery quick because of its perishable nature, and its receivable turnover is higherbecause most customers pay in cash. The receivables result from the paymentsdue from franchisees.

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EXERCISES

E5-25. (30 minutes)

a.($ millions)

Target [$2,929 + $869x(1-.35)] / $45,168 = 7.74%

Wal-Mart [($16,387 + $2,322x(1-.35)] / $446,950 = 9.57%

b.($ millions) PM = EWI / Sales AT = Sales / Avg. Assets

Target [$2,929 + $869x x(1-.35)] / $69,865 =5.00%

$69,865/$45,168= 1.55

Wal-Mart [($16,387 + $2,322x (1-.35)] / $446,950= 4.00%

$446,950/$187,094= 2.39

c. Wal-Marts ROA is greater than Targets in fiscal 2011. Wal-Marts value pricingstrategy is clearly evident in its lower PM, but this is more than offset by a higherasset turnover and, hence, Wal-Marts business model is somewhat moresuccessful.

E5-26. (20 minutes)

a.Case A B C D E F

Assets 1,000 1,000 1,000 1,000 1,000 1,000Non-interest-bearing

liabilities 0 0 0 0 200 200Interest-bearing liabilities 0 250 500 500 0 300Shareholders equity 1000 750 500 500 800 500

Earnings before interestand taxes 120 120 120 80 100 80

Interest expense 0 25 50 50 0 30

Earnings before taxes 120 95 70 30 100 50Tax expense (40%) 48 38 28 12 40 20Net income 72 57 42 18 60 30

ROE 7.2% 7.6% 8.4% 3.6% 7.5% 6.0%ROA 7.2% 7.2% 7.2% 4.8% 6.0% 4.8%ROFL 0.0% 0.4% 1.2% -1.2% 1.5% 1.2%

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M5-26. concluded

b. These three cases differ only in the amount of interest-bearing liabilities used tofinance the firm. As leverage increases, the return to shareholders equity (ROE)increases. However, the return on assets (ROA) does not change, because the

ROA is independent of the way that the business was financed.

c. However, financial leverage (the use of liabilities to finance the firm) does not alwayswork in favor of shareholders. The liability holders require a fixed return (6% after-tax = 10% x (1 40%)), and in order for leverage to work in favor of shareholders,the overall return on assets must exceed this fixed return. In case C, the return onassets is 7.2% > 6%, so ROFL is positive. In case D, the return on assets is 4.8%

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