in-class exercises. financial statement analysis 1 hint: group industries into more general classes:...
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In-Class ExercisesIn-Class Exercises
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Financial Statement Analysis 1
Hint: Group industries into more general classes:• Financial services• Capital intensive• Technology oriented• Service Firms (basketball franchise is a partnership)
• Consumer Foods• Retail
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Financial Services
• Finance companies lend money, therefore carry large receivables – Firm 13 (General Motors Acceptance Company)
• Life Insurance companies must keep large reserves they pay to customers– Firm 11 (U.S. Life Corporation)
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Capital Intensive
Have large amounts of Property Plant & Equipt.• Firms 9 and 12• Steel companies sell a commodity that has
experienced intense global competition – low profit margins, #9 is Inland Steel
• #12 is Consolidated Edison
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Consumer Foods
Heavy advertisers (remember the Superbowl?)– Firms 4 and 7
– Distilled spirits tend to be aged longer than beer, resulting in a lower inventory turn
Firm 4: inventory turn = 62/5.6 = 11.1 times/yr
Firm 7: inventory turn = 46.5/21.7 = 2.1 times/yr
– Firm 4 is the brewer (Anheuser Busch) and firm 7 is the distiller (Brown-Forman)
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Technology- Oriented
• R&D expenses are higher– Firms 3, 5, and 8
– Pharmaceutical companies have typically had high margins – 8 (Merck)
– Aerospace often receives advances on contracts, R&D cost is embedded in particular contracts (CGS).
Firm 3 is Aerospace (Rockwell International) and firm 5 is Computer (Data General)
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Service Firms
Have few depreciable assets– Firms 2 and 10
– Firm 2 pays no income taxes as a partnership (Boston Celtics), firm 10 is the advertising agency (Ogilvy)
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Retailers
Department stores carry receivables and have a lower inventory turnover than grocery stores, so firm 6 is a department store (May Dept. Stores) and firm 1 is a grocery (Supermarkets General).
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S-T Debt Paying AbilityWorking Capital
This Year Last Year
Current assets $2,060,000 $1,470,000
Current liabilities 1,100,000 600,000
Working capital $ 960,000 $ 870,000
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S-T Debt Paying AbilityCurrent Ratio
This Year Last Year
Current assets $2,060,000 $1,470,000
Current liabilities $1,100,000 $600,000
Current ratio 1.87 to 1 2.45 to 1
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S-T Debt Paying AbilityAcid-test Ratio (Quick Ratio)
This Year Last Year
Quick assets $740,000 $650,000
Current liabilities $1,100,000 $600,000
Acid-test ratio 0.67 to 1 1.08 to 1
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Liquidity Activity RatioAverage Age of Receivables
This Year Last Year
Sales on account $7,000,000 $6,000,000
Average receivables $525,000 $375,000
Turnover of receivables 13.3 times 16.0 times
Avg age of receivables: 365 ÷ turnover
27.4 days 22.8 days
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Liquidity Activity RatioInventory Turnover
This Year Last Year
Cost of goods sold $5,400,000 $4,800,000
Average inventory $1,050,000 $760,000
Inventory turnover 5.1 times 6.3 times
Turnover in days: 365 ÷ turnover
71.6 days 57.9 days
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Ability to Meet L-T ObligationsDebt-to-Equity Ratio
This Year Last Year
Total liabilities $1,850,000 $1,350,000
Stockholders’ equity $2,150,000 $1,950,000
Debt-to-equity ratio 0.86 to 1 0.69 to 1
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Ability to Meet L-T Obligations Times Interest Earned
This Year Last Year
Net income before
interest and taxes $630,000 $490,000
Interest expense $90,000 $90,000
Times interest earned 7.0 times 5.4 times
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Analysis of Liquidity
Working capital has increased, however, its current position actually has deteriorated significantly since last year.
• Both the current ratio and the acid-test ratio are well below the industry average, and both are trending downward.
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Analysis of Profitability
The company has improved its profit margin from last year.
• This is attributable to an increase in gross margin, which is offset somewhat by an increase in operating expenses.
• In both years the company’s net income as a percentage of sales equals or exceeds the industry average of 4%.
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• The inventory turned only 5 times this year as compared to over 6 times last year.
• It takes three weeks longer for the company to turn its inventory than the average for the industry (71 days as compared to 50 days for the industry).
• This suggests that inventory stocks are higher than they need to be.
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• The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory.
• This is evident both from the common-size balance sheet and from the financial ratios.
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• Notice that the average age of the receivables has increased by 5 days since last year, and that it is now 9 days over the industry average.
• Many of the company’s customers are not taking their discounts, since the average collection period is 27 days and collection terms are 2/10, n/30.
• This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Perhaps the company has been too aggressive in expanding its sales.
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Loan Approval Option
• The loan may be approved on the condition that the company take immediate steps to get its accounts receivable and inventory back under control.
• This would mean more rigorous checks of creditworthiness before sales are made and perhaps paring out of slow paying customers.
• It would also mean a sharp reduction of inventory levels to a more manageable size.
• If these steps are taken, it appears that sufficient funds could be generated to repay the loan in a reasonable period of time.